Question

Identify a change in fiscal policy that will shift the composition of output toward investment. Present a composition of output analysis to explain why the policy you suggest will tend to shift the composition of output toward investment.  

Answer 1

If we adopt contractionary fiscal policy which reduces the government spending and raises taxes such that it lowers the disposable income of consumers and reduce the aggregate demand of them. Contractionary fiscal policy will shift the IS curve to its left from IS to IS1 which will reduce the rate of interest from "i" to "i1" and lower the output level from "Y" to "Y1". As rate of interest have reduced, there will be rise in investment level because fall in interest rate result in fall in cost of borrowing of loans.