Question

2) In 2001, the Fed pursued a very expansionary monetary policy. At the sametime, President George W. Bush pushed through legislation that lowered income taxes. a. Use the IS-LM diagram to describe the situation prior to any such policy changes labeling the economy initially at the equilibrium at point A. b. Now show the combined effect of the two policies. Label the new equilibrium point B. Explain what you have done - which curve shifts which way and why! c. Why would these policies be pursued?

Answer 1

a) Initially the economy is at A where real interest rate is r1 and GDP is at Y1.

b) Lowering taxes is a part of fiscal expansion that raises real GDP in goods market. This is likely to shift the IS curve outwards. At the same time there is a monetary expansion so money supply is increased. This is also likely to raise real GDP so LM curve shifts out. We are finally at B where equal size shifts have caused no change in the real interest rate but real GDP has increased

c) These policies might have been pursued to combat a recession. By lowering taxes the aim was to raise consumption. By reducing interest rates via money supply increase, the aim was to raise investment. Both of them are expected to raise aggregate spending and thus, real GDP

LM, Real interest LM2 rate, 12 В IS 2 IS Income, Output, Y Y, Y, ҮЗ