Answer to Question #190162 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).

Answer 1

If the LM curve is vertical, then an increase in government spending will not affect the value of the equilibrium income and will only lead to an increase in the interest rate. This case is shown in the figure, where an increase in government spending shifts the IS curve to the IS ' position, but has no effect on income. If the demand for money is not related to the value of the interest rate, as the vertical LM curve suggests, then there is a single level of income at which the money market is in equilibrium.

Therefore, with a vertical LM curve, an increase in government spending cannot change the level of the equilibrium income and only increases the level of the equilibrium interest rate. But if public spending has increased and output has not changed, then there should be a counterbalancing reduction in private spending.

Based on the above, it is necessary either not to change public spending or to change public spending with an increase in output: public investment in production, so that there are no displacements