Many people associate high budget deficit with high interest rates and rising prices. Taxes are primarily...

Many people associate high budget deficit with high interest rates and rising prices. Taxes are primarily linked to income. Throughout this problem, assume that T=tY, where t is the net tax rate.

USE IS-LM and AD-AS frameworks to explain whether this association (that is, high budget deficits with high real interest rates and rising prices) is true in the short run, if the deficits are primarily due to expansionary fiscal policy (like increases in government purchases).
Use IS-LM and AD-AS frameworks to explain whether this association is true in the short run, if there is a sudden decline in consumer or business confidence.

Expert Solution

i)Due to an expansionary fiscal policy as a result of an increase in the government purchases. In the IS-LM framework, the IS curve will shift upwards with no change in the LM curve since the money market remains unaffected in this case. Since the IS shifts upwards and to the right there is an increase in the interest rates and hence income. In the AD-AS framework, the AD curve shifts up and to the right (due to a shift in the IS curve) as a result of which the output and price levels increase. So the mentioned association is true in the Short Run, high expansionary fiscal policy leads to higher interest rates and higher prices.

ii) Due to a sudden decline in consumer or business confidence, two variables get affected either the consumption(consumer side) or investment(business side). A decline in either leads to a downward shift in the IS curve and LM curve remains unaffected. As a result of which the interest rates and the income level fall.

In the AD-AS framework, the AD curve shifts downwards as a result of downward shift in the IS curve. Because AD curve shift downwards and AS curve remains unchanged. The price level and income level falls.

So the association of high interest rates and higher prices is false in the Short Run in this case.

Rahul Sunny answered 8 months ago

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