Question

Answer the following question using a properly- labelled IS/LM diagram. Be certain to explain your answers!

Suppose that, due to a recession, the economy is in equilibrium at a low level of output, Y0. Further suppose that the government chooses to use fiscal policy to increase output to a higher level. Explain the mechanism (e.g. the chain of causality, ensuring that you explain the “crowding out effect” in the process) by which a fiscal expansion will affect equilibrium output Y and interest rates r. Be certain to show this effect on your diagram. (NOTE: although this question only asks you to explain fiscal policy, you should be able to answer a similar question regarding the use of monetary policy instead!)

Answer 1

If government uses fiscal policy to increase the level of output, IS curve shifts to the right. At the unchanged interest rate, this causes aggregate demand to increase. Firms find their inventories running down which is compensated by increasing production of output. In the figure below output increases to Y'' at the unchanged interest rate. Here goods market is in equilibrium but Money market is not.

As equilibrium income increases, transaction demand for money increases. Excess demand for money for given level of money supply pushes interest rates upwards. Higher interest rate make many investment projects unprofitable leading to decline in planned investment spending and therefore aggregate demand. So final equilibrium output is at Y₀'.

At unchanged interest rate, fiscal expansion has the maximum impact on output. Output increases from Y₀ to Y''. But actual increase in output is from Y₀ to Y₀'. Impact of fiscal expansion is dampened due to increase in interest rate. Extent of increase in interest rate depends on sensitivity of money demand to income and therefore on the slope of LM curve. Increase government spending causes increase in interest rate which further causes private investment to decline. This process is called crowding out.