Question

Declining interest rates are good for an economy, since interest sensitive spending will increase. Furthermore, since...

Declining interest rates are good for an economy, since interest sensitive spending
will increase. Furthermore, since a decrease in a government budget deficit (by
decreasing government spending and/or raising taxes) increases national savings, and
thus, reduces the real interest rate, a deficit-reduction policy will have an expansionary
effect in the economy due to the increase in interest sensitive spending; Is this reasoning
correct? Use the IS-LM framework to explain your answer.

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Answer #1

Answer: The following is the IS-LM figure for the question. The reasoning that is given in the question is correct.

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Explanation: The initial equilibrium point where both the money and the goods market is in equilibrium occours at point E1 where the IS curve intersects the LM curve. Now with the decrease in the government spending or an increase in the taxes the IS curve shifts leftword. The new equilibrium point is now at E2 where both the rate of interest and level of output is lower. The new interest rate is i' and the new level of output is Y'. Now since the interest rate is lower, this means that the level of investment will be higher in the economy. A higher level of investment will lead to an overall increase the level of output. This is how a deficit reduction policy will lead to an overall expansion of the economy.

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