Question

Suppose that in a closed economy the fiscal policy is contractionary and monetary policy is expansionary, and the central bank is setting the interest rates (LM is horizontal). Graphically analyze this policy mix by using IS-LM diagram. What will be the impact on real income and on interest rate in the short run? What will be the impact of this policy mix on the economy in the medium run? Show by using an AD-AS-LRAS diagram.

Answer 1

Contractionary fiscal policy shifts IS curve backward to IS1 while expansionary monetary policy will shift LM curve to its right to LM1. It will reduce rate of interest from "i" to "i1" while keeping output same at Y*. It shift the economic equilibrium from point A to B in short run.

As rate of interest is decreased, it reduces cost of borrowing for investors which tends to raise investment level.

Aggregate demand = Consumption + Investment + Government spending + Exports - Imports

Rise in investment level will raise aggregate demand in the economy which shifts demand crve to its right from AD to AD1. It will raise price level from P to P1 and raise output level from Y to Y1 in short run.

In medium run, producers will raise supply of goods after observing rise in demand in short run which will shift supply curve to its right from S to S1. It will reduce price to its initial level while raising output level further.