In the IS-LM framework if the government performs contractionary ﬁscal policy, what can Fed do to...

In the IS-LM framework if the government performs contractionary ﬁscal policy, what can Fed do to help the economy return to its original equilibrium output?

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Expert Solution

Suppse Government Increases Taxes(a Contractionary Fiscal policy). Increase in Taxes shifts the IS Curve to the left. This reduces both the interest rate and Output in the Economy. To stimulate an economy after Increase in T(Taxes) so that Economy could return to the original level of Output(Output prevailing before Increase in Taxes), suppose, Fed Increases the money supply. Increase in money supply shift the LM Curve to the right. This New LM curve cuts the New IS Curve at a point which is the new Equilibrium point for the Economy. At this point, the interest rate gets reduced further and the Output in the Economy returns to the original level. This is shown in the Diagram below. E" is the new equilibrium with a lower interest rate as compares to previous equilibrium interest rate and unchanged output.

Rahul Sunny answered 2 years ago

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