Answer to Question #113713 in Macroeconomics for Anshika

Question

What combination of monetary and fiscal policy should the government use if it wants to reduce the budget deficit, but without reducing the output? Explain using a diagram.

Answer 1

Let's assume that the government is concerned about the budget deficit and decides to increase taxes. Let's look at the impact this policy will have on the economy as a whole. According to the IS-LM model, the results will depend on what policies the Central Bank will implement in response to tax increases. There are several possible options.

The Central Bank maintains a constant supply of money (figure a). The tax increase shifts the IS curve to the left (down) to the IS2 position. As a result, aggregate output decreases (higher taxes reduce consumer and investment spending) and the interest rate decreases (lower income reduces the demand for money).

The Central Bank maintains the interest rate at a constant level (figure b). In this case, the tax increase also shifts the IS curve to the left (down) to the IS2 position, while the Central Bank reduces the money supply so that the interest rate remains at the original level, the LM curve shifts to the LM2 position. Revenue is reduced by an amount greater than in figure a. In the first case, a lower interest rate encourages investment and partially offsets the effect of tax increases. In this case, the Central Bank ,by keeping the interest rate at a high level, deepens the downturn in the economy.

The Central Bank increases the supply of money to keep the income level constant ( c).tax Increases will not cause a drop in aggregate output, since the LM curve shifts down to the LM2 position to offset the shift in the IS curve (higher taxes reduce consumption, while a lower interest rate encourages investment). In this case, an increase in taxes contributes to a drop in the interest rate.

This example illustrates that the effects of fiscal policy depend on the policy of the Central Bank, i.e. whether he maintains a money supply, interest rate, or income level at a constant level.

By combining fiscal and monetary policy, it is possible to achieve solutions to more complex problems than simply regulating the volume of output (for example, without changing the volume of output, change its structure). Such a task can be very relevant if the economy is in a situation of full employment and, therefore, a change in output is undesirable, but its structure may require a change.