Question

What happens to the strength of a fiscal stimulus when the central bank holds the money supply constant? Explain.

Answer 1

If money supply doesn't Increase following a fiscal stimulus, It means that IS Curve shifts outwards in the IS-LM framework whereas LM Curve remains same. Rightwards shift in only IS Curve would lead to an increase in interest rate. Increase in interest rate crowds out Private Investment. Thus, the strength of fiscal stimulus becomes less as compared to a situation when following a fiscal stimulus, money supply is also Increased. In this situation when money supply is Increased after fiscal stimulus, it brings down the increased interest rate(which went up due to the fiscal stimulus) to its initial level. Thus, there is no crowding out and the effect of fiscal stimulus on output in the Economy is highest.

Hence, if money supply is held constant when there is a fiscal stimulus, the strength of fiscal stimulus is lower due to Crowding out of Private Investment.