Question

Using the IS-LM model and assuming the central bank conducts monetary policy by manipulating the cash rate, explain the effects of:: Fiscal policy designed to offset the impact of a decrease in the marginal propensity to consume (assuming an unchanged monetary policy);

Answer 1

Fiscal policy designed to offset the impact of a decrease in the marginal propensity to consume :

A decrease in marginal propensity to consume of the individual will reduce the level of consumption expenditure in the economy.As cinsumption expenditure decreases in the economy aggregate demand falls and output falls leading to recessionary gap in the economy. To offset the impact of decreased MPC, the government should increase its expenditure and reduce taxes which will also increase consumption expenditure and thus shift the IS curve of the economy rightwards to IS'. In the diagram below, the rightward shift of the IS curve to IS' will move equilibrium from point E₁ to point E₂ and this leads to increase in the rate of interest and increase in the level of national output in the economy. This can be depicted in the diagram as: