Question

Express the fiscal and monetary policies as well as their combined use in the IS/LM model. While observing "The US recession of 2001", think through the effectiveness of the policy mix adopted to aid recovery. Then consider the recession that the US is currently experiencing: argue on the basis of your understanding of IS/LM and the current US macroeconomics trajectory for a specific fiscal and monetary policy response.

Answer 1

In the IS-LM model, monetary policy has no effect on the IS curve but expansionary monetary  policy shifts the LM curve down.With expansionary monetary policy there will be increase in the money supply and there will be a fall in the interest rate.The fall in the interest rate increases the demand for investment which exerts a multiplier effect on consumption.

During the US recession of 2001 ,fiscal policy was used to increase aggregate demand in response to the recession.Government spending increased and tax cuts were used to stimulate household income and spending.The aim of monetray policy was to increase the level of economic activity by a increase in money supply. The central bank used the expansionary monetary policy to increase the money supply,bring a reduction in interest rate ,increase the quantity of loans . All these increased demand and shifted the aggregate demand curve to the right.

The recent recession and the financial crisis that US is experiencing has made the monetary and fiscal policymakers to take unconventional and aggressive actions.Fiscal policy makers increased government spending and reduced taxes .Increase in government expenditure will shift IS curve to the right.The federal funds rate is lowered which gives incentive to the firms to expand.At lower interest rate there will be more investment.At present fiscal policy can play the role of giving the right incentive to the firms.US government is providing funds for banks to make loans.The aim of fiscal policy in normal recession is to support aggregate demand but this is not a normal recession and so tax cuts may lead to inflation.So trying to increase aggregate demand beyond disaster relief , is not a wise decision.