Question

IS-LM What combination of policies would best reduce inflation? a) Increase taxes, sell government bonds b) Decrease taxes, buy government bonds c) Decrease taxes, lower the reserve ratio d) Decrease government spending, lower the discount rate e) Increase government spending, raise the discount rate Use the IS-LM model. Your policy instruments are: Taxes, Government Spending, and the Money Supply. Describe a policy or set of policies that achieve the following objectives. Your answer should include a diagram to show how your policy achieves the goal. Raise investment without altering the money supply. Implement a large tax cut without raising the interest rate

Answer 1

(1) (a)

Increase in tax will decrease consumption, shifting IS curve to left, reducing output. Lower output lowers inflation rate. Also, selling bonds will decrease money supply, shifting LM curve leftward, reducing output. Lower output lowers inflation rate.

(2)

In both graphs, IS0 & LM0 are initial IS & LM curves intersecting at point A with initial interest rate r0 and output Y0.

(A)

To increase investment, interest rate has to be reduced. Money supply (LM curve) remaining the same, interest rate will fall if IS curve shifts to left. This can be done by increasing tax (which decreases consumption and output) or decreasing government spending (which decreases output).

In following graph, when government increases tax or decreases spending, IS0 shifts left to IS1, intersecting LM0 at point B with lower interest rate r1 and lower output Y1.

Y LMO rot 8 150 +I5 Y Yo Y

(B)

A tax cut increases consumption, which shifts IS curve to right, increasing interest rate. To keep interest rate unchanged, money supply has to be increased, which shifts LM curve rightward, decreasing interest rate.

In following graph, when government decreases tax, IS0 shifts right to IS1, intersecting LM0 at point B with higher interest rate r1 and higher output Y1. To keep interest rate the same, LM0 shifts rightward to LM1, intersecting IS1 at point C at initial interest rate r0 but further higher output Y2.

X 151 LMO 15. sy B LM А. ro Yo Yo Y2 Y