Question

Use the IS-LM framework to carefully explain how such an expansionary fiscal policy, either tax cut or government spending increase or both, affects the equilibrium output, interest rate and investment.

Answer 1

Expansionary fiscal policy is used by the government when it is willing to increase the real GDP in the economy. This can be done by either increasing the government spending or by initiating tax cuts. This increases the government expenditure and disposable income so that consumption expenditure is increased. the multiplier effect magnifies the initial increase in government expenditure and it increases the real GDP so that the IS curve shifts to the right. As a result the equilibrium output and interest rate both are increased. Investment is reduced because of higher interest rate and this decreases the initial increase in the real GDP. At the new equilibrium, still, both the real GDP and interest rate are higher