Question

(1) Describe the impact of the 2008-2009 financial crisis to the economy on the IS-LM graph, specifically to the equilibrium output and interest rate.

(2) Illustrate on the IS-LM graph how an expansionary fiscal policy could help the economy to recover from the recession. What will happen to the investment during this recovery process under only the fiscal policy?

(3) Discuss on the IS-LM graph how an expansionary monetary policy could help the economy to recover from the recession. What will happen to the investment during this recovery process under only the monetary policy?

Answer 1

1. During the crisis, the IS curve shifted left.

–Household wealth decreased and consumer optimism went down

–Business pessimism spread

–Greater difficulty in obtaining loans

As a result of the leftward shift in the IS curve, the equilibrium output as well as the equilibrium rate of interest has fallen down.

2.

.

The expansionary fiscal policy would shift the IS curve to the right. An expansionary fiscal policy may be adopted by either increasing the public expenditure or by cutting down the taxes. This would increase the rate of interest as well as real output in the market.

3.

Expansionary monetary policy

The expansionary monetary policy would make the LM curve shift to the right. This will reduce the rate of interest and increase the national income. Since rate of interest is also falling down, this can promote investment from the part of the private sector. WE will be able to recover from the crisis much quicker.

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