Answer to Question #115951 in Macroeconomics for Anshika

Question

Central bank can keep either the money supply or interest rate constant. Under which case, will the fiscal policy have the strongest effect on the output and why? Explain using a diagram.

Answer 1

Fiscal policy is a term which refers to the ways the government adjusts its spending levels and tax rates in order to monitor and influence a nation's economy. Fiscal policy can increase employment levels by helping to increase aggregate demand (AD) and the rate of economic growth. We are going to use the IS-LM graphs to discuss these effect.

 In the short run an increase in the money supply shifts the LM curve to the right .This improves the economy from point A to point B this is due to the fall of interest rates from r1 to r2.The output rises from Y to Y2 because the lower interest rate stimulates investment, which increases output. Prices will begin to increase since the level of output will be above its long run level.

Real balances will be lowered as price levels begin to fall this will result to the LM curve shifting to the left. In the long run there will be no impact resulting from increase in money supply .The interest rates will return to r1 and the investment level will return back to the original place. It can be illustrated by the following graph.