Answer to Question #125451 in Macroeconomics for Ankit

Question

The economy is at full employment. Now the government wants to change the composition of demand toward investment and away from consumption without, however, allowing aggregate demand to go beyond employment.
(i) What is the required policy mix?
(ii) Use an IS-LM diagram to show your policy proposal.

Answer 1

I) Fiscal policy

Fiscal policy can lead to an increase in Aggregate Demand and rise in real Gross Domestic Product . The increase in economic growth will cause increased demand for workers, providing employment and reducing unemployment.

Fiscal expansion will raise the demand for goods and services. This greater demand leads to increases in both output and prices.

ii)The impact of fiscal policies in the IS-LM model depends also on interest elasticity of the transaction demand for money.

In the diagram below, as the LM curve becomes flatter due to interest elasticity of the transactions demand for money, a shift of the IS curve to the right increases Y from Y0 to Y2 which is greater than the increase from Y0 to Y1 when the LM curve is less flat, i.e., when interest elasticity of transactions demand for money is zero.