Answer to Question #109344 in Macroeconomics for Anishi

Question

Suppose the government increases the expenditure . Use the IS - LM model to show the impact of the increase in government expenditure under two assumptions :
i. The government keeps interest rates constant through an accomodating monetary policy.
ii. The money stock remains unchanged.
Use suitable diagram

Answer 1

i.

Let the government increase government purchases by financing them with debt. For every possible value of the interest rate of the ego, ceteris paribus causes a shift curve IS to the right by or depending on the assumptions made about the tax function (T = Ta or T = Ta + tY). Figure a shows that, firstly, the result of such a policy in the short term is an increase in output from Y1 to Y2 and an increase in the interest rate from r1 to r2, and secondly, if the interest rate remained constant at r1, then the aggregate output would grow from a multiplier effect to a value of Y3.

The reason that the increase in government procurement (lower autonomous taxes) is accompanied by a smaller increase in total output than in the Keynesian Cross is due to the crowding out effect. If government purchases increase (autonomous taxes are reduced), then total spending and income increase, which leads to an increase in consumer spending. An increase in consumption, in turn, increases total spending and income, with a multiplier effect. At the same time, demand begins to grow in the money market, since a larger volume of transactions is made in the economy with an increase in output. With the initial interest rate and constant supply of money, an increase in demand for money in the money market creates a deficit, which leads to an increase in the interest rate. An increase in the interest rate reduces the investment costs of the private sector and contributes to a trend towards a decrease in total output.

ii.

The government is pursuing a stimulating fiscal policy: it increases government spending and reduces taxes. This causes the IS curve to shift upward to the right, while the LM curve remains unchanged. To maintain equilibrium in the real and money sectors, a higher interest rate and a higher level of real income are now required. With an increase in government spending ΔG, real income in the economy should increase by ΔG / (1 - MPC), i.e. manifests a cartoon effect. Therefore, initially, at the same interest rate, a new equilibrium will be established at point E2.

However, at this point there is an excessive demand for money, which causes an increase in the interest rate. This increase in interest rates continues to the level corresponding to point E1, when excess demand for money disappears. However, point E1 corresponds to a lower (compared to exact E2) level of real income. The multiplier of total costs cannot be fully manifested in this case because of the crowding out effect, which is that an increase in the interest rate leads to a reduction in private investment and private consumption. Despite the crowding-out effect, aggregate demand is growing from Y * 0 to Y * 1.