Question

1. Based on your understanding of the IS-LM model, graphically illustrate and explain what effect a monetary expansion will have on output, the interest rate, and investment.
2. Increases in the budget deficit are believed to cause reductions in investment. Based on your understanding of the IS-LM model, will a fiscal policy action that causes a reduction in the budget deficit cause an increase in investment? Explain.
3. First, briefly explain what is meant by the policy mix. Second, explain what effect different policy mixes might have on the level of output, investment, and the interest rate.
4. Use the IS-LM model to answer this question. Suppose there is a simultaneous increase in government spending and reduction in the money supply. Explain what effect this particular policy mix will have on output and the interest rate. Based on your analysis, do we know with certainty what effect this policy mix will have on investment? Explain.
5. Use the IS-LM model to answer this question. Suppose there is a simultaneous increase in taxes and reduction in the money supply. Explain what effect this particular policy mix will have on output and the interest rate. Based on your analysis, do we know with certainty what effect this policy mix will have on investment? Explain.

Answer 1

IS MODEL : IS Curve represents different combination of Income and Interest rate where Goods market is in equilibrium. Goods market equilibrium requires that output level eqauls to Aggregate spending ie, Y = AD.

As per below graph, At int. rate i1 , oods market is in equilibrium at income level Y1 because at that Y = AD. When Int. rate reduces to i2, then AD curve shifts upwards due to increase in investment.As a result, equilibrium level of income increases to Y2. By joining all such combinations , we get downward sloping IS Curve.

LM Model : LM curve repesents different combination of income and int. rate at which Money market is in equilibrium. Equilibrium in money market requires equality of Demand of Money and Supply of Money.

Demand for money is Liquidity preference . Demand for Money is inversely relaed with Int.rate and directly with income . This is because Int, rate is opportunity cost for holding cash. So at higher int. rate, people will prefer to hld less cash. On the other hand, at higher income levels , thete will be more transactions as income rises. Supply of money is assumed to be constant

As per LM Curve in below graph, At y1 level of income, Money market isin equilibrium at i1 int rate.At any int rate below i1, people will prefer to hold more cash. For this purpose poeple will sell bonds which reduces the value of bonds and thereby increases its int. rate . So int rate will continue to change so that equilibrium is attained in Money market. When income increases to Y2, demand for money rises, due to this int. rate rises to i2. By joining all such combinations, we get the upward sloping LM curve.

IMPACT OF MONETORY EXPANSION ON IS-LM MODEL :

The below graph shows the impact of loose Monetory policy in Money market. Since LM curve represents the Money markrt, there will be an impact on LM cuve. Bank conducts monetory policy through open market opeartins mainly which relates to int.rate and purchse of govt. bonds. Monetory policy works through Trasmission Mechansim by 2 steps.

1. In the fisrt step, Increase in money supply generates disequilibrium .It means that at existing int. rate and level of income people will hold more more money than they want. As a result, portfolio holders try to reduce money holding by purchsing other assets like bonds. As a result value of bond inreases and rate of interest decreases ( Movement from E1 toE2)

2. In the secondstep of transmissionmechansim , chage in interest rate affects aggregate demand. Infact, A fall in int. rate leads to increase in agg. demand , mainly investment spending.Due to this, there will be increase in int rate and economy moves along the curve to E3.

The result is rightward shift LM curve from LM1 to LM 2. and Monetory policy will be completely effective.

IMPACTOF FISCAL POLICY ON IS-LM MODEL TO REDUCE BUDGET DEFICITA AND INCREASE INVESTMENT.

To increase investment and reduce deficit , government will adopt expansionary Fiscal policy. Due to the loose fiscal policy , may be in thr form of govt. expenditure or reduction in taxes, IS curve will shift righwards from IS1 to IS2 curve an there will be excess demand for goods. As s result, output increases in subsequent period. With increase in output, there will be increase in demand for money because money demand varies directly with Income . However with given money supply , there will be excess demand for goods.Due to this interest rate rises and crowds out some private investment ( Movement from E3 to E2). Due to this complete effect of fiscal policy ( Output could increase more at equilibrium point E3 but could increase upto pint E2 due to increase in int. rate) is not realized. So, there will be some crowding out of pvt investment due to Fiscal expansion.

POLICY MIX :

Policy mix refers to combination of Monetory policy and Fiscal policy . To attain equilibrium level in Goods market and Money market, Fiscal policy, Monetory policy, or combination of both can be used.

Simultaneous increase in government spending and reduction in the money supply.

Under the below graph of IS -Lm model, IS curve will shift righwards from IS1 to IS2 due to increase in government spending. There is Simultaneous fall in money supply in the money market which will shift the LM curve leftwards from LM1 to LM2. Due to Fiscal expansion there will be some crowding out effct and increase rate (to i2) will increase due to excess demandof goods at given money supply. Monetory contraction will furthet raise the int. rate to i3 which further damen the inverstment as it will increasethe cost of borrowing for private investors.At even higher int. rate people will demand less goods and invest more money in different portfolios.

Simultaneous increase in taxes and reduction in the money supply.

The below graph shows thw impact of increased taxes and decreased Money supply in IS-LM model. Due to increased taxes there will be fiscal contraction in the goods market which will shift the IS curve leftwards from IS to IS2 which will lead to fall in int. rate . There will full crowding out of private investment at such increased interest rate. There is Simultaneous contraction in money market in the form of reduced Money supply which will shift LM curve leftwards from LM1 to LM2 which will tend to increase the int. rate and lower level of output demand as people will hold less cash at higher interest rate and spend less than to output which demotivate pvt investors to invest.

.