Question

Suppose that the government wants to increase its expenditure g and has the options of financing it by higher taxes, bond issues or increases in the monetary base. Further, when g is increased through bond or monetary financing, the central bank can also undertake offsetting open market operations. What combinations, if any, of financing methods and open market operations will allow the following goals to be met in the IS–LM model.

(i) No change in aggregate demand;

(ii) No change in investment;

(iii) No change in aggregate demand and investment?

Answer 1

i) selling bonds by central bank will reduce the money supply in the economy causing a contraction of LM curve and a contraction of output. To offset this impact if government increases expenditure it will lead to expansion of is curve offsetting the above effect as a result there will be no change in AD. Similarly if central bank purchases bonds and government reduces the expenditure the AD will be unaffected as the fiscal and monetary policy cancel out each other's effects

ii) if government expenditure increases by deficit financing then IS curve will shift to the right and the AD will expand and it might affect the investment but if central bank sells bonds it will offset the impact of fiscal policy causing the inflow of cash in the economy to be reversed

iii) If government increases expenditure in the form of decrease in taxes it will shift the IS curve to the right and central bank increases the rate of interest to offset the fiscal policy expansion as a result the investment which would have expanded initially will contract and so will the AD as a result the net impact will be no change.