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What policy mix of monetary and fiscal policy is needed to meet the following objectives? Illustrate...

What policy mix of monetary and fiscal policy is needed to meet the following objectives? Illustrate using IS-LM diagrams.

a.       Increase Y while keeping the interest rate constant. Explain what the CB has to do to keep the interest rate constant. Would investment change?

b.       Decrease a fiscal deficit while keeping Y constant. Why must the interest rate also change?

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Answer #1

a) Increase output while keeping the interest rate constant will need to increase the autonomous expenditure i.e. government expenditure and adopt a deficit budget. This will increase the interest rate in the economy, To keep the interest constant at the earlier level the CB need to adopt an easy money policy. Yes, investment in the economy will increase because of increased demand.

b) To decrease the fiscal deficit while keeping the output constant the government need to decrease the expenditure i.e. shift the IS curve to the left and the central bank needs to decrease the interest rates to increase the output and investment. This will shift the LM curve to the right.

  

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