Question

6. If the objective is to increase Y* (in order to lower unemployment) using an increase in government spending, but without causing a decrease in private spending, what additional policy would be needed to achieve this objective? Show the effect on the IS-LM model. What is this type of policy called? 10 points.

Answer 1

There are two policies that the government can use to bring about a change in output: Monetary and Fiscal policy.

Fiscal policy: this is the initial policy where the government increases its spending, resulting in a rightward shift in the IS curve. However, this would also lead to an increase in the rate of interest which could lead in reduced private spending. There is a need to prevent this.

Monetary policy: this is the additional policy required to combat the fall in private spending. When the central bank increases money supply in the economy, it leads to a fall in the rate of interest as the LM curve shifts to the right.

The original rate of interest is secured and there is no crowding out of private investors. The result includes an increase in output, i.e. fall in unemployment.