Question

Suppose that North Korea has a closed economy and that its government wants to raise investment but keep output constant (i.e. no change in Y but with a higher I). In the closed economy IS-LM model, what mix of monetary and fiscal policy will achieve this goal? Use a graph to support your answer.

Answer 1

Investment can be increased by expansionary fiscal policy (by increasing G or decreasing T), which increases output. Increase in output will increase investment, which will shift IS curve to right, increasing both interest rate and output.

To keep output constant, central bank will use contractionary monetary policy which will decrease money supply and decrease output. LM curve will shift to left, increasing interest rate and restoring output to initial value.

In following graph, increase in investment shifts IS0 rightward to IS1, which intersects LM0 at point A with interest rate r1 (higher than initial interest rate r0) and output Y1 (higher than initial output Y0). Lower money supply shifts LM0 leftward to LM1, intersecting IS1 at point C with further higher interest rate r2 (> r1 > r0) but initial output Y0.