Question

Use the IS-LM analysis to explain the following. Please also state what determines the size of effect on GDP and interest rates. What are the effects on the AD analysis? Try to use graphs and pictures to answer your questions.

a) Government spending decreases

b) The central bank increases policy rates

c) Government increases taxes.

Answer 1

A)

Decrease in government spending is contractionary fiscal policy which shift IS curve leftward from IS to IS' which leads to fall in interest rate from I to I' and decrease income from Y to Y'.

Decrease in government spending shift AD curve leftward from AD to AD' and fall prices from P to P' and decrease GDP from Y to Y'.

B)

Increase in interest rate is contractionary monetary policy which leads to shift in LM to leftward from LM to LM' which tends to reduce income from Y to Y'.

As interest rate increase investment falls so aggregate demand falls and curve shift leftward from AD to AD' which tends to fall in prices and fall in GDP.

C)

Increase in taxes is again contractionary fiscal policy which tends to shift IS curve leftward and income and interest rate falls.

Also aggregate demand fall and price and real GDP falls.

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