1. When the government decrease the budget deficit, what happens to IS, LM and Aggregate Demand?...

1. When the government decrease the budget deficit, what happens to IS, LM and Aggregate Demand?

2. When the government increase the budget deficit, what happens to IS, LM and Aggregate Demand?

3. When Central Bank purchases bonds, what happens to IS, LM, and Aggregate Demand?

Could someone help answering these questions?

Expert Solution

1. A budget deficit implies that spending by government exceeds its revenue. When the government decreases the budget deficit, it is called as a contractionary fiscal policy. It is possible by decreasing government spending and/or increasing taxation.

Lets take the case of a decrease in government spending.

-In terms of the IS-LM model, a decrease in government spending causes a decrease in the demand for goods and the level of output declines and unemployment rises. This is represented by a leftward shift of the IS curve

2. When the government increases the budget deficit, it is called as an expansionary fiscal policy. An increase in the money supply decreases the interest rate and as the interest rate is decrease investment spending, the demand for goods and the level of output rise. In terms of our IS-LM model, this is represented as a rightward shift of the LM curve.

3. Quantitative easing is a monetary policy used by the central bank, whereby it purchases financial assets from commercial banks and other private institutions. The aim is to inject money into the economy, thereby lowering interest rates and inducing investments to increase output.

The effect of the expansionary monetary policy of quantitative easing causes the LM curve to shift outwards. However, there is no shift in the IS curve except for a movement along the line

Rahul Sunny answered 2 years ago

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