Question

This year the government of Bangladesh has introduced a fiscal stimulus package that significantly increases public expenditure. Because the government has problems borrowing in domestic and international credit markets these days, it asks the Central Bank of Bangladesh to print money and buy government bonds, so that the government will have sufficient money to spend.

Assume that the exchange rate is flexible and that the interest parity condition holds. Also, assume that the price level is exogenously determined and the conditions in the rest of the world remain unchanged. Finally, assume that the government's policy is viewed as temporary and has no impact on the course of the economy beyond the current year.

How would this policy affect the levels of private consumption and investment in Bangladesh this year?

	a.	Private consumption and investment will both rise.
	b.	Private consumption and investment will both decline.
	c.	Private consumption will rise and investment will decline.
	d.	Private consumption will rise, but investment may rise or decline.
	e.	Private consumption will remain unchanged, while investment will rise.
	f.	Private consumption will decline, while investment remains unchanged.

Answer 1

Private consumption will rise, but the investment may rise or decline.

Explanation:

IS-LM framework shows the relationship between the interest rate and national income of the economy.

IS curve shows the combination of points that shows the relationship between the interest rate and national income where the goods market is in equilibrium. LM curve shows the relationship between the interest rate and national income where the money market is in equilibrium. At the equilibrium point, equilibrium interest rate and equilibrium national income is obtained.

An increase in government expenditure will lead to an increase in the aggregate demand for goods in the economy. As a result, there will be a rightward shift in the IS curve in the economy. To finance this increase in government expenditure, the government will order the central bank to print more amount of currency. As a result, the money supply will increase and the LM curve will shift to the right.

Therefore, national income increases, and a change in the interest rate will depend on the magnitude change in the IS and LM curve. As we know that consumption directly depends on the national income so consumption expenditure will increase and change in investment will not be determined.