Answer to Question #102087 in Macroeconomics for Harman

Question

The government cuts public spending. a)Use the IS-LM-model to explain what happens to national income. Explain the effects on goods and money market separately and the interaction of these markets.
b)Which role does the marginal propensity to consume play for the effect on income?
c)Under the assumption that the central bank is responsible for price stability, what will be the appropriate monetary policy action? Use your IS-LM model for your argumentation.

I know what would happen if the government were to increase spending but I'm having trouble answering this question about the government cutting public spending.

Answer 1

a) The production-interest balance in the IS-LM model is determined separately for each of the markets, that is, for both commodity and money markets.

b) Marginal propensity to consume is defined as the proportion by which revenue from goods and services has increased compared to the previous period.

c) When the angle of the LM graph is steeper than 1, we have to move this graph more than IS. However, IS can be displaced either by increasing government spending or reducing taxes. LM can be reduced by increasing the money supply (which can be achieved by purchasing bonds from the Central Bank). And if we consider directly the components of GDP, then here the investments will increase due to the increase in production; consumption will increase more or less depending on the type of fiscal policy used); government spending will only increase if fiscal policy is implemented by increasing government spending.