Answer to Question #194001 in Macroeconomics for Nkeletsang Marupin

Question

(B) The economy is at full employment. The government now wants to change the composition of demand towards investment and away from consumption without allowing aggregate demand to go beyond full employment. What is the required policy mix? Use the IS-LM analysis to show the policy proposal. (10 marks).

Answer 1

Solution:

If the government wants to change the composition of GDP towards investment and away from consumption without changing the level of aggregate demand, it is required to implement a combination of restrictive fiscal policy and expansionary monetary policy.

This will result in an increase in personal income taxes or a decrease in transfer payments, which will reduce consumption and thus aggregate demand. The IS curve will shift to the left, leading to a decrease in output and the interest rate. To increase output to its original level, the government can undertake expansionary monetary policy. This will shift the LM curve to the right, leading to a further decrease in the interest rate hence stimulating investment and in turn aggregate demand. If the intersection of the new IS and LM curves are at the same income level as initially, then the decrease in the interest rate will have stimulated investment spending sufficiently to exactly offset the decrease in consumption

This is depicted by the below graph: