Question

Question 1

a) Explain the effect on the equilibrium interest rate and output level of an increase in the real money supply, state if this is an contractionary monetary or fiscal policy and show the effect graphically. fully label the graph (10)

b) Explain the effect on the equilibrium interest rate and output level of a decrease in taxation. State if this is an expansionary or contractionary monetary or fiscal policy and show the effect graphically. (10)

Answer 1

a)

An increase in the real money supply is called as "Expansionary Monetary Policy".

In below graph, IS is a downward sloping curve that represents the equilibrium in goods market. LM is the upward sloping curve that represents the equilibrium in money market. Both curves interest at point E at which both money and goods market are in equilibrium. The equilibrium output is Y1 and the interest rate is r1.

Now, an increase in the real money supply leads to more money in the hands of the public. People will, therefore, start demanding more goods and services. As a result, the LM curve shifts rightward and intersects the old IS curve at point E1. At this point, there is a lower interest rate and higher output level.

b)

The decrease in taxation is called "Expansionary Fiscal Policy". Due to fall in the tax rates, the IS curve shifts to the right. The new equilibrium point is now at E1. At this point, there is higher interest rate and higher output level.

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