Question

Impact of Covid-19 and how Monetary and Fiscal policy change the IS-LM model.

Answer 1

The COVID-19 pandemic has led to lower aggregate demand, household consumption and business investment. This will lead to a leftward shift in IS curve, decreasing both interest rate and output.

In following graph, IS0 & LM0 are initial IS & LM curves intersecting at point A with initial interest rate r0 and output (real GDP) Y0. Due to COVID, IS0 shifts left to IS1, intersecting LM0 at point B with lower interest rate r1 and lower GDP Y1.

To boost demand and output, two policy measures are available:

(1) Expansionary fiscal policy

Government may implement expansionary fiscal policy to increase aggregate demand, by increasing government spending and/or by decreasing taxes. In either case, IS1 will shift rightwards until it restores to IS0, at initial equilibrium point A.

(2) Expansionary monetary policy

Central bank may implement expansionary monetary policy to increase aggregate demand, by open market purchase of securities, by decreasing required reserve ratio and/or by decreasing discount rate. In either case, this increases money supply. LM0 shifts right to LM1, intersecting IS0 at point C with further lower interest rate r2 but restoring output to Y0.