Suppose that there is a fiscal contraction and a monetary contraction. This will cause: a. output...

Suppose that there is a fiscal contraction and a monetary contraction. This will cause:

a. output and interest rates to both remain constant

b. output to fall but interest rates may rise, fall, or remain the same

c. output and interest rates to fall

d. interest rates to fall but output may rise, fall, or remain the same

Expert Solution

Fiscal contraction implies that whether the tax rate increases or the government expenditure on goods and services decreases or there may be the combination of both that implies that the IS curve will shift to the left which will further cause the output and interest rate to decrease. On the other hand, monetory contraction implies that the central bank will reduce the money supply via open market operations which will increase the interest rate in the economy and shift the LM curve to the left which implies the interest rate will go up and the output will decrease. So we can see, that the output will decrease for sure but the change in the interest rate depends on the magnitude of shift in the IS curve and LM curve, therefore, the right answer is option B.

Rahul Sunny answered 2 years ago

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