Question

14. Consider an economy in which the default risk premium rises due to a financial crisis.

a. Use the IS-LM model to illustrate and explain how this shock affects the equilibrium level of output.

b. How can the government use the fiscal policy to counter the impact of this shock? Explain.

c. How can the central bank use the monetary policy to counter the impact of this shock? Explain.

d. What are the advantages/disadvantages of using the fiscal vs. the monetary policy under these circumstances? Explain.

Answer 1

a) Higher level of default risk leads to higher required return inturn a higher intrest rate.

• With the increase in intrest rate, the equilibirum level raises from E to E1
• IS curve shifts to rightward.
• Is curve shows the every point relationship between interest rate and real GDP
• People demand less money when the intreset rate is high, but people demand more money when the their income raises, hence LM curve doesnot change

b) Contractionary fiscal policy

• i and Y are the original intrest rate and income in the economy
• beacuse of the contractionary fiscal policy, the government decreases the expenditure
• this in turn decreases the prodcution in the economy,
• this shifts the IS curve to left

c) Expnasionalry monetary supply

• Increase in money supply, reduces the interest rate
• This decrease in investment spending and aggregate demand
• this in turn shifts the equilibirum level back to E from E1

d) Advantages and disadvantages of Fiscal policy

Advantages:

1. Direct spending on a specific issue by intorducing policies.
2. Government can use taxation as tool, to effect the negative externalities.

Disadvantages:

1. Sometimes create budget deficits.
2. involevement of politics affects the solution to the economic problem

Advantages and disadvantages of Monetary policy

Advantages:

1. As the central bank focuses on controlling inflation, it the best organisation to introduce tools to control inflation
2. It is politically neutral, as it is an independent orgnization

Disadvantages:

1. Techinal limitations, sometiems it may affect liquidity trap
2. Monetary policy is implemented to the entire country, may be it may not focus on bridges gap in some parts of the country.