Question

Suppose the US government wants to stimulate GDP by $3 billion in the short run, and is trying to decide between using either monetary policy or fiscal policy (in particular, a tax cut).

i. Draw a separate IS-LM diagram for each of these policies in the short run; label the policy above each graph. Be sure to label the axes, the curves, and use arrows showing the direction the curves shift. Explain each curve shift briefly.

ii. Discuss the differences in the effects of the two polices on i). the real interest rate and ii). total national saving.

iii. If the US government’s goal were to raise GDP by the $3 billion amount, while keeping national saving as high as possible (since its already very low in the US),which policy would be the better choice? Explain your reasoning.

Answer 1

i. When a fiscal policy (a tax cute) is implemented, this will increase the disposable income of the people. This will increase the amount people consume more. Thus shifting IS curve to the right from IS1 to IS2, increasing gdp from Y1 to Y2 and interest rate from r1 to r2 . The economy moves at a higher equilbrium from e1 to e2 along the lm curve LM.

When monetary policy is implemented (e.g increasing money supply or decreasing fed funds rate), this shifts the LM curve to right from LM1 to LM2. This increases GDP from Y1 to Y2 and decreases interest rate from r1 to r2. The economy moves to equilibrium e2 from e1 along the IS curve. The intution is that this put more money in hand of people at lower interest rates, which expands aggregate spending and hence output in the economy.

ii. (i) In case of fiscal policy, the real interest rate will rise while in the monetary policy case, the interest rate will decrease.

(ii) In case of fiscal policy, a increase in disposable income increases the amount of consumption. As income is either consumed or saved. The impact here is that savings decrease and hence national saving falls. This is one reason why interest rate rise for the fiscal policy. While due to monetary policy there is increased money supply i.e increased supply of lonable funds which means amount quantity of saving is more and hence national saving is more. This is the reason interest rate falls in the monetary policy case. (Think of the market for lonable funds)

iii. If the governent wants national savings to be as high as possible it must use a monetary policy. A fiscal policy will expand consumption and deplete national savings, while a monetary policy expands the quantity of lonable funds in the economy and expands national savings.