Question

Explain the IS-LM model, and then use it to describe the difference between expansionary fiscal policy and expansionary monetary policy in the case where the economy finds itself well below its full employment level of output.

Answer 1

The IS-LM model shows the optimum combination of the interest rate and real output that brings the goods market and money market in equilibrium simultaneously. LM curve (L-liquidity, M-money) shows an equilibrium in the money market and is an upward sloping line showing a positive relationship between the real output and the interest rate. Each point of the LM curve has an equilibrium in domestic money market. Similarly, IS curve (I-investment, S-spending) has an equilibrium in the goods market. showing a negative relationship between the interest rate and real output. Each point of the IS curve shows an equilibrium in goods market.

When the economy finds itself well below its full employment level of output there is a recessionary gap. An expansionary fiscal policy shifts the AD curve in the goods market to the right, raising the inflation rate, interest rate and real output. In IS-LM model, this is shown by a rightward shift in the IS curve. Here real interest rate and real output is increased in the short run. An expansionary monetary policy shifts the AD curve in the goods market to the right, raising the inflation rate, reducing the interest rate and real output. In IS-LM model, this is shown by a rightward shift in the LM curve. Here real interest rate is decreased and real output is increased in the short run. Hence, the difference between expansionary fiscal policy and expansionary monetary policy lies in the treatment towards money market and rate of interest.