Question

5. Compare the effects of expansionary monetary and fiscal policy on the interest rate in the IS-LM model. (5 points)

Answer 1

Solution

Effect of Fiscal Policy:

Let us first explain how IS-LM model shows the effect of expansionary fiscal policy of increase in Government expenditure on level of national income.

This is illustrated in Increase in Government expenditure which is of autonomous nature raises aggregate demand for goods and services and thereby causes an outward shift in IS curve, as is shown where increase in Government expenditure leads to the shift in IS curve from IS₁ to IS₂

Expansionary Fiscal Policy: Reduction in Taxes:

An alternative measure of expansionary fiscal policy that may be adopted is the reduction in taxes which through increase in disposable income of the people raises consumption demand of the people. As a result, cut in taxes causes a shift in the IS curve to the right as is shown from IS₁ to IS₂.