Question

Question 3 The effect of a contractionary fiscal policy on the economy depends on the central’s bank response to the fiscal policy. Consider a closed economy, and the government conducted a contractionary fiscal policy. The central bank responds to this fiscal policy by holding the interest rate constant. Use the IS-LM model and the money market diagram to illustrate graphically the impact of this contractionary fiscal policy on output and interest rate given the response of the central bank.

Be sure to label:

The axes

The curves

The initial equilibrium point

The direction the curves shift

The final equilibrium point

Answer 1

(a) IS-LM model

Contractionary fiscal policy shifts IS curve to left, lowering interest rate and output. To keep interest rate unchanged, central bank uses Contractionary monetary policy which shifts LM curve to left, raising interest rate to its original level, reducing output.

In following graph, IS0 and LM0 are initial IS and LM curves intersecting at point A with initial interest rate r0 and output Y0. When IS0 shifts left to IS1, interest rate falls, to keep which unchanged, money supply is decreased to shift LM0 leftward until it gets to LM1, intersecting IS1 at point B with same interest rate r0 and lower output Y1.

(b) Money demand-supply model

Contractionary fiscal policy lowers interest rate and output. Lower output lowers the demand for money, shifting money demand curve to left, reducing interest rate and quantity of money. To keep interest rate unchanged, central bank uses Contractionary monetary policy which shifts money supply curve to left, raising interest rate to its original level, reducing the quantity of money.

In following graph, MD0 and MS0 are initial money demand and money supply curves intersecting at point A with initial interest rate r0 and quantity of money M0. When MD0 shifts left to MD1, interest rate falls, to keep which unchanged, money supply is decreased to shift MS0 leftward until it gets to MS1, intersecting MD1 at point B with same interest rate r0 and lower quantity of money M1.