Question

When East Germany and West Germany were reunited in 1990, the West German government accepted the obligation to attempt to raise living standards in the eastern part of Germany rapidly. This required an immediate increase in government purchases to assist with East German infrastructure and transfer payments to the residents of the former East Germany. For political reasons, the German government did not want to raise taxes much. In effect, the government ran an expansionary fiscal policy. The German central bank, the Bundesbank, did not want to raise aggregate demand, though, and attempted to keep the income in the economy at the current level. Illustrate this fiscal policy-monetary policy mix using an IS/LM diagram. What happens to interest rate with this policy mix? What happens to investment with this policy mix? Explain your answers.

Answer 1

I am able to explain only IS-LM framework. Sincere Apology for not explaining with the country.

he general equilibrium is basically determined in collaboration of two kind of markets. Namely the goods market and money market. Here we have the the curves namely for two different markets. Assuming IS curve for goods market and LM curve for money market. IS stands for investment and saving, and LM stands for Money Supply (liquidity preferences) available for investing. LM curve is upward slopping left to right direction positively slopped and IS is negatively slopping i.e. left to right downward slopping curve.

The intersection between IS and LM curve determines the general equilibrium of interest rate. on Y axis the rate of interest is determined. and on X axis the income is determined. In other words, when there is a single pair of interest rate and income leve in the product and money markets that the two markets are in equilibrium.

In the diagram point E is the original equilibrium and the Y₂ level shows the income on X axis and R₂ level show the rate of interest on Y axis.

If LM curve shifts upward Consider the original LM Curve as

LM₀ and new LM curve as LM₁ on the given IS curve and the new equilibrium is established say E₁. The rate of interest decreases to R₁ from R₂ and simultaneously the level of income increases from Y₂ to Y₃.

The shifting of the IS curve to the right on given LM curve. from Consider original IS curve is IS₀ to IS₁ and the new equilibrium is established E_1. This shows the higher level of income at Y₃ and shows the increased rate of interest from R₂ to R₃.