Question

The government should never use monetary policy to combat business cycle fluctuations coming from changes in money demand if they also wish to keep short run movements in consumption to a minimum. Is her claim true, false or uncertain? Explain with the help of an IS/LM diagram.

Answer 1

The claim is True.

Let money demand increase. This will shift the money demand curve rightward, thus shifting the LM curve leftward, increasing interest rate and decreasing output. Since lower output will decrease consumption, the government should attempt to increase output using expansionary fiscal policy (note that monetary policy is always conducted by central bank and not by government). An expansionary fiscal policy will shift the IS curve rightward, increasing output until it is restored to original level, thus stabilizing consumption, though interest rate will be higher.

In following graph, IS0 and LM0 are initial IS and LM curves intersecting at point A with initial interest rate r0 and output Y0. As LM0 shifts left to LM1, it intersects IS0 at point B with higher interest rate r1 and lower output Y1. Government's expansionary fiscal policy will shift IS0 rightward to IS1 which intersects LM1 at point C, with higher interest rate r2 and same output Y0.