Answer to Question #190248 in Macroeconomics for Dephnie Lambi

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

IS-LM model shows the equilibrium in the money market and goods market. The Shape of IS-LM curves calls for the change in monetary or fiscal policy: The LM curve being vertical suggests that fiscal policy or IS curve changes will not be effective in raising the income level. The rise in government expenditure or going with the expansionary fiscal policy will cause a rise in the interest rate only or GDP or income level remains unaffected.

Following is the diagram:

In this diagram, the LM curve is vertical which means a change in the IS will not be effective in increasing the income level.

Thus, here we should not go with fiscal policy, instead, monetary policy will prove effective in raising the income level. Rise in money supply will shift the LM curve to right thereby leading to the rise in the income level.

 

The vertical shape of LM curve implies that full crowding out occurs due to a rise in government expenditure. hence, government should not follow the fiscal policy, and monetary policy must be used to produce maximum effects.