Question

1.      a. What, if anything, does expansionary fiscal policy do in the i-M space graph, cet. par.? Explain. Indicate the disequilibrium that is created at the initial interest rate and explain what will happen and why.

b. There is a liquidity trap in the i-M space graph. Show what this means in the i-M graph and then explain what type of macro policy will not work.

Answer 1

a ) Whenever there is expansiory Fiscal Policy , this will shift the IS curve outwards . It increases expenditure on goods and services which will boost the domestic production of goods and services . LM curve is not getting affected by this policy change . Earlier , IS LM curves intersected at point A now due to fiscal policy IS curve shifted rightwards as a result equilibrium interest rate and income(output) rises that is from Yo to Y1 and I0 to I1 .

b ) Liquidity Trap is a situation when LM curve is horizontal and IS Curve is downward sloping . Here interest rates are very low and savings rate are very high . In this situation , monetary policy becomes ineffective . Suppose there is expansionary monetary policy that is increase in money supply , public is prepared to hold on whatever money is being supplied at given interest rate as savings are high . There will be no change in output level .