Question

4. Suppose policymakers want to raise investment but keep output constant. In the IS-LM model, what combination of policies could be used to achieve these goals? Use graphs and explanations to thoroughly explain.

Answer 1

contractionary fiscal policy :

• contractionary fiscal policy and expansionary monetary policy will lead to achievement of this result, as when there is contractionary fiscal policy( like increased taxes), there will be a backward shift in IS curve thus decreasing interest rates and decreasing output, to compensate for the decreased output the central bank can increase money supply this will lead to rightward shift in LM curve thus further decreasing interest rates and stabilizing output, now as interest rates are the opportunity cost of investment so decreased interest rates will lead to higher investment in the economy.

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What is the IS-LM Model:

• The IS-LM model, which stands for "investment-savings, liquidity-money," is a Keynesian macroeconomic model that shows how the market for economic goods (IS) interacts with the loanable funds market (LM) or money market. It is represented as a graph in which the IS and LM curve intersect to show the short-run equilibrium between interest rates and output.
• The IS-LM model appears as a graph that shows the intersection of goods and the money market. The IS stands for Investment and Savings. The LM stands for Liquidity and Money. On the vertical axis of the graph, ‘r’ represents the interest rate on government bonds. The IS-LM model attempts to explain a way to keep the economy in balance through an equilibrium of money supply versus interest rates.

Effect of Fiscal Policy:

• Let us first explain how IS-LM model shows the effect of expansionary fiscal policy of increase in Government expenditure on level of national income.
• This is illustrated in Fig. 2 Increase in Government expenditure which is of autonomous nature raises aggregate demand for goods and services and thereby causes an outward shift in IS curve, as is shown in Fig. 20.6 where increase in Government expenditure leads to the shift in IS curve from IS₁ to IS₂.
• Note that the horizontal distance between the two IS curves is equal to the increase in government expenditure times the government expenditure multiplier, that is, ΔG x 1/1-MPC which shows the increase in national income equal to the horizontal distance EK that occurs in Keynes’ multiplier model. However, in IS-LM model actual increase in national income is not equal to EK caused by the working of Keynesian multiplier.
• This is because with the rightward shift in IS curve rate of interest also rises which causes reduction in private investment. It will be seen from Fig. 20.6 that, with the LM curve remaining unchanged, the new IS₂ curve intersects LM curve at point B. Thus, in IS-LM model with the increase in Government expenditure (ΔG), the equilibrium moves from point E to B and with this the rate of interest rises from r₁ to r₂ and income level from Y₁ to Y₂.
• Income equal to CK has been wiped out because of rise in interest causing a decline in private investment. Thus CK represents crowding-out effect of increase in government expenditure Thus, IS-LM model shows that expansionary fiscal policy of increase in Government expenditure raises both the level of income and rate of interest.

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