Answer to Question #190679 in Macroeconomics for Graylin lapi

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

An economy where money demand only depends upon income and is not influenced by interest rates is characterized by a vertical LM curve. 

In a scenario like this, fiscal policy has no effect on output or income, for it can only impact interest rates. In order to influence income, fiscal policy becomes ineffective. Only monetary policy, that would shift the LM curve is effective.

Therefore, an expansionary fiscal policy will shift IS rightward to IS2. This will increase the interest rate, without any impact on the level of income.

Due to a rise in interest rates and an increase in the aggregate level of demand, the cost of borrowings will increase for the private sector. Thus, they would borrow less and private spending will reduce, thus a crowding-out effect on private investment.

If I'm the economic planner, I would introduce an expansionary monetary policy. The aim would be to lower the interest rates so that private spending is not discouraged.

Due to an increase in money supply to due expansionary monetary policy, the LM curve would shift towards the right, thus increasing the equilibrium level of income.