Answer to Question #116706 in Macroeconomics for Bayramhan Demircan

Question

For this question assume that the real money demand function is L(R, Y) = kY - hR where
k > 0 represents the sensitivity of the money demand to income and h > 0 represents the
sensitivity of the money demand to the interest rate.
Suppose that the economy of Highland has high k and low h, while the economy of Lowland
has low k and high h. If the two countries are the same other than the above difference,
compare and contrast the short run effectiveness of the fiscal policy in Highland and
Lowland.

Answer 1

The government also influences investment, employment, output and income in the economy through fiscal policy. For an expansionary fiscal policy, the gov­ernment increases its expenditure or/and reduces taxes. This shifts the IS curve to the right. The government follows a contractionary fiscal policy by reducing its expenditure or/and increasing taxes. This shifts the IS curve to the left.

Figure illustrates an expansionary fiscal policy with given IS and LM curves. Suppose the economy is in equilibrium at point E with OR interest rate and OY income. An increase in govern­ment spending or a decrease in taxes shifts the IS curve upwards to IS which intersects the LM curve at E₁ .This raises the national income from OY to OY₁.The rise in the national income increases the demand for money, given the fixed money supply. This, in turn, raises the interest rate from OR to OR₁.The increase in the interest rate tends to reduce private investment expenditure at the same time when the government expenditure is being increased.

The relative effectiveness of fiscal policy depends on the slope of the LM curve and the IS curve. Fiscal policy is more effective, the flatter is the LM curve, and is less effective when the LM curve is steeper. When the IS curve shifts upwards to IS₁with the increase in gov­ernment expenditure, its impact on the national income is more with the flatter LM curve than with the steeper LM curve.