Answer to Question #189348 in Macroeconomics for Rolin Simo

Question

1.     Show using the IS-LM graph the impact of an expansionary fiscal policy if the LM curve is vertical. If you were the Economic Planner in this country, how would you implement the fiscal policy without causing any crowding out of private investment? (You may insert a snapshot of the graph if drawn manually) (5 marks).

Answer 1

Fiscal policy also attempts to influence aggregate demand in an economy by influencing tax-expenditure programme of the government. A cut in taxes or an increase in government spending causes a shift in the IS curve in the rightward direction. Fiscal policy is completely ineffective, if the LM curve is vertical. It means that the demand for money is perfectly interest inelastic.

Crowding out clearly weakens the impact of fiscal policy. The reverse of crowding out occurs with a contractionary fiscal policy—a cut in government purchases or transfer payments, or an increase in taxes. Such policies reduce the deficit (or increase the surplus) and thus reduce government borrowing, shifting the supply curve for bonds to the left.