Question

The IS curve represents goods-market equilibrium. Consumption depends positively on disposable income; investment depends negatively on the real interest rate; tax and government spending are exogenous. Following a large negative shock to confidence, investment demand falls and the IS curve shifts to the left, intersecting the LM curve at i = 0.

Use the IS-LM model to analyse the effects on GDP of each of the following policy options. Which policies does the model predict are effective in avoiding a recession?

i. The central bank increases the money supply by buying more short-term government bonds (‘quantitative easing’);

ii. Higher government expenditure paid for by increasing taxes;

iii. A tax cut paid for by printing money (a ‘helicopter drop’ of money);

iv. The central bank raises its inflation target (assume this is credible and increases inflation expectations π^e)

Answer 1