Question

In the IS-LM model there is similtaneous decrease in tax and interest rate, the central bank controls the interet rate

a) discuss the magnitudes, slopes and their impact on policy effectiveness

b) Explain what effect this particular policy mix will have on output and the money supply.

c) Based on your analysis, do we know with certainty what effect this policy mix will have on invedtment use diagrams

Answer 1

In IS -LM Model ,IS curve shows the goods market equilibrium and LM curve shows the money market equilibrium.

In IS LM model,two major type of policy is the fiscal policy and monetary policy.Fiscal policy deals with the government spending and tax rate,while monetary policy deals with the money supply and interest rate.

The LM curve,the equilibrium points in the Market for money,shifts for two reasons: changes in money demand and changes in the money supply.If the money supply increases, interest rate is lower,the LM curve shift right.That is because at any given level of output, more money means a lower interest rate.

An expansionary monetary policy could be an ideal choice in such a situation. By increasing the money supply it is possible to shift the LM curve to the right, reduce r and raise aggregate demand and enable the economy to reach point E”. Alternatively by using an expansion­ary fiscal policy it is possible to shift the IS curve to the right and enable the economy to reach point E’.

Finally a combination of the two policies can be used to an enable the economy to reach the point of full employment.

An expansionary monetary policy can be used to stimulate the interest-elastic component of aggregate demand (mainly investment spending and, in particular, residential construc­tion). In truth, monetary policy has the immediate and the strongest effect on residential construction.

In contrast, the effect of fiscal policy depends on exactly what goods the government buys or what changes it incorporates in the tax-transfer programmes.

Each policy affects the level of aggregate demand, but the composition of output will differ from case to case. A cut in corporate tax rates affects both investment spending, and, through distributed profits, personal consumption.

A personal income tax cut has a direct effect on consumption spending. Given the quantity of money, all expansion­ary fiscal policies raise the interest rate.

In IS LM Model ,the rate of interest is decreased when investment will be increased because the reducing intereste rate,investors will get more loans this will increases the money supply this central bank enters and control the rate of interests.