Suppose that the government wants to raise investment but keep output constant. In the IS-LM model,...

Suppose that the government wants to raise investment but keep output constant. In the IS-LM model, what mix of monetary and fiscal policy will achieve this goal? In the early 1980’s, the US government cut taxes and ran a budget deficit while the Fed pursued tight monetary policy. What effect should this policy mix have?

Expert Solution

If government wants to raise investment, it will raise aggregate demand because

Aggregate Demand = Consumption + Investment + Government Spending + Exports - Imports

As aggregate demand rises, IS curve shifts to its right raising rate of interest from "i" to "i1" as well as level of output from "Y" to "Y1".

As they wants to keep output level constant at Y, they will adopt tight monetary policy which will reduce the supply of money in the economy and shifts LM curve backwards which will raise rate of interest further to "i2" and take output back to its initial level.

In 1980 when government reduced taxes which must had direct impact on consumption due to rise in disposable income. It must have also shifted IS curve to its right. Tight monetary policy were also adopted. Thus, I can say that the impact that time muct have been same as depicted in the graph above where rate of interest must have increased while output stay constant.

Rahul Sunny answered 2 years ago

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