Question

If the Government increased its expenditures to 10%, identify one monetary policy adjustment that might be used by the Federa Reserve in response to the fiscal policy change.

i). identify the response

ii). Predict the policy's change's effect on interest rate (if None, write None)

iii). Explain why they would respond at such

Answer 1

a) If government responds to increasing its expenditure, aggregate demand in an economy will rise (aggregate demand and government spending have positive relationship with each other). It will cause IS curve to shift to its right from IS to IS1 and raise interest rate from "i" to "i1" and output to rise from "Y" to "Y1"

Fed will come with contractionary monetary policy to reduce the output such that it stays at its long run equilibrium. It will shift LM curve to ts left from LM to LM1 causing interest rate to rise further to "i2" and output to fall at its initial level.

b) Both policies would lead to rise in interest rate.

c) As governemnt spending raises aggregate demand in the economy, people will have more willingness to pay for goods. Investors would be willing to invest even at higher rate of interest because they know they will cover their money due to high demand in the market.

Due to Fed contractionary monetary policy, there will be reduction in money supply. As money demand is more than money supply, people would be more reluctant to pay higher rate of interest to borrow money which cause rate of interest further.