Question

Assume that the IS and LM curves have normal slopes. Contractionary fiscal policy: a. increases the...

Assume that the IS and LM curves have normal slopes. Contractionary fiscal policy:

a. increases the interest rate but decreases income

b. shifts the LM curve to the left

c. shifts the IS curve to the right

d. lowers both income and the rate of interest

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Answer #1

Answer to the question:

Option d: Lowers both income and the rate of interest.

Explanation: A contractionary fiscal policy is in the form of lower public expenditure and/or higher tax will cause the real income of the people to decline and in turn this will cause the consumption to decline. As a result, the IS curve will shift inward to the left and given the LM curve unchanged, both the equilibrium rate of interest and the equilibrium income will decline.

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