Question

Apply the IS/LM graphical framework to explain the following question (show using the IS/LM graphs). In the early1980’s, to combat the recessionary forces, President Ronald Reagan used expansionary fiscal policy by lowering (marginal) tax rates to combat the recession. Concurrently, Paul Volcker, Chairman of the Federal Reserve Board of Governors, reduced the rate of growth of the money supply (reduction in the money supply) to combat inflation. Explain the total effect of these policies on real gross domestic product, interest rates, employment and inflation.

Answer 1

There is a policy mix of expansionary fiscal policy and contractionary monetary policy. While fiscal expansion of tax cuts is likely to boost GDP in the goods market, monetary contraction is likely to raise interest rate in assets market. As a result, IS shifts to the right and LM shifts to the left. Rate of interest is increased in both cases. Final effect on GDP is ambiguous because fiscal expansion increases it while monetary contraction decreases it. Here it is assumed that the size of shifts are same so GDP remains unchanged