Question

a) Use the IS/LM/FE framework to identify the macroeconomic effects of a wave of investor pessimism about the future profitability of capital investments.

b) Discuss policy tools that are available for the government to help with the situation in (a) and identify the pros and cons of the different tools.

c) Provide your policy recommendation and carefully support your recommendation for this case.

Answer 1

A wave of investor pessimism about future profitablility of capital investments raises concern among them, thus reducing investment activity in the economy. A reduction in investment activity shifts the IS curve towards the left as shown in figure(a) from IS to IS'. This leads to a fall in output and the rate of interest. [IS = C + I + G + NX]

To return to the equlibrium state, an economy always has two tools: Fiscal Policy and Monetary policy. In the question given, the government can help the economy to return to its initial position by raising its expenditure so that IS curve shift out to the right and has its equilibrium achieved again. This increase in govt expenditure is shown in fig(b) as a shift from IS to IS' and hence a return to the equilibrium level of output. The government also has the option to reduce the tax burden on people and thus indirectly raising consumption expenditure and thus a shift in the IS curve. This will also help in achieving equilibrium position.

However, there are certain pros and cons to these government decisions, they are explained as below:

Pros:-

1) Aimed at specific purpose - Unlike monetary policy, govt ependiture is more specific in nature meaning the govt can easily increase its expn in the sector which it wants to develop the most.

2) Shorter time lag - Unlike monetary policy, fiscal policy have a shorter time lag meaning its effects can be seen much quicker as compared to other tools.

3)Pushes growth in the economy.

Cons:-

1) May be politically motivated.

2)Leads to huge burden on general budget.

3)Crowding out of private investment.

However, only if a fiscal measure is desired ( as in the given question) then increasing govt expn and reducing tax both can increase output and hence are good policy options for the government keeping in view their importances.