Question

Show short-term and long-term equilibrium for an economy that experiences a combination of expansionary monetary and expansionary fiscal policies. Use IS/LM, AS/AD, and Money market diagrams. Explain logic behind curve shifts.

Answer 1

Expansionary monetary policy is the policy of the central bank which leads to an increase in the supply of money in the economy. It is also known as easy monetary policy. On the other hand, expansionary fiscal policy is of the government and leads to an increase in the aggregate demand in the economy. It is also known as easy fiscal policy.

IS-LM curve show the goods and money market equilibrium respectively. When the government uses it's expansionary fiscal policy, the IS curve shifts to the right to IS1. Because there is an expansionary monetary policy as well so the LM curve will also shift to the right to LM1. This will lead to an increase in the level of output keeping the rate of interest unchanged.

If we see the AD-AS market, we see that with an expansionary monetary and fiscal policy, the AD curve and the AS curve both shift to the right to AD1 and AS1. The output level increases whereas the price level remains unchanged.

With an expansionary monetary policy, the money supply in the economy increase which leads to a shift in the money supply curve MS to MS1. Because of an expansionary fiscal policy the people in the economy will demand more money which will lead to a shift in the money demand curve MD to MD1. Thereby increasing the quantity of money keeping the nominal interest rate unchanged.

This is how expansionary monetary and fiscal policy affect the IS-LM, AD-AS AND Money Market.

In the long run, the output increases. The rate of interest and price level may increase or decrease depending on the magnitude of change in the policy. Multiplier will play a key role in determining that.