Question

"Is it possible to attain successful fiscal consolidation, no output and employment loss, or better still, growth and employment creation?" Does a policy mix exist that attains this outcome? True or False. Explain in words and refer to the augmented IS-LM model when needed.

Your answer: True .... False ... Explanation:

Answer 1

Yes it is true that it is possible to attain fiscal consolidation through which government can reduce its public debt by adopting contractionary fiscal policy through which they can reduce government spending and raise taxes. Both of these factors will reduce the aggregate demand and shift the IS curve to its left from IS to IS1 which reduces the rate of interest from "i" to "i1" and output fall from "I" to "I1".

This is only true when Fed raise the money supply by adopting expansionary monetary policy which shifts the LM curve to its right from LM to LM1 which will reduce the rate of interest further to "i2" level and take output level to its initial level of "I".

Thus it is possible with the policy mixture of contractionary fiscal policy and expansionary monetary policy that output level remains the same which cause no employment change but reduce the rate of interest which will raise the investment level in the economy and finally raise the aggregate demand.