Question

Draw a graph of the product market to explain why output might go up if expansionary monetary and fiscal policy is adopted, and why output might fall back down to its original level. Please explain your graph

Answer 1

The above diagram represents the effect of expansionary monetary and fiscal policy on the product market.

Expansionary Monetary Policy

When the central bank employs the expansionary monetary policy method to boost the economy, it generally does that by pumping money i.e.by increasing the money supply. With the increase in money supply, the interest rate fall down (money supply and the interest rate has negative relation). This encourages the investors to invest more. This creates employment which leads to the growth of output. The AD curve upwards to AD1. With the increase in GDP, there is also increase in price. The price changes from P0 to P1. If the central bank does not control inflation soon the economy will face the situation of stagflation. Hence, to bring back the economy into their normal position, the central bank will take away the excessive money from the economy. This can be done by issuing bonds into the market or by increasing the interest rate.

Expansionary Fiscal Policy

In expansionary fiscal policy, the government either increase the spending or deduct the tax rate. The AD curve shifts to right due to an increase in the disposable income with the consumers. The output grows with the increase in the price level.