Question

Suppose government expenditures are decreased, taxes rise and the supply of money increase leaving output unchanged. Using the IS-LM model explain the impacts of these policies on the level of interest rates and the level of investment spending

Answer 1

Suppose the supply of money increase which shifts the money supply curve to the right, as a part of monetary expansion. This shifts the LM curve to the right. Interest rate is reduce but real GDP is increased. This is shown by a movement from A to B.

Now assume that government expenditures are decreased. This will be a part of fiscal contraction and thus IS curve will shift inwards. At the same time, taxes rise and this will discourage consumption and investment. IS curve will shift further inwards. The effect of this shift is a further reduction in the rate of interest and the real GDP of the nation. This is shown by a movement from B to C

These two events will result in a reduction in the rate of interest but the real GDP will remain unchanged. This is true because the size of shifts in IS and LM are same. So fiscal contraction reduces real output while monetary contraction increases it, leaving it unchanged.