Answer to Question #198240 in Macroeconomics for Anisha Kumar

Question

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

The E (equilibrium) in the commodity market is demonstrated by the IS curve. The equilibrium in the MM (money market) is demonstrated by the LM curve. An EFP (expansionary fiscal policy) refers to an increase/rise in government expenditure or reduction/fall in taxes. 

When there is EFP in the economy, the government would either raise the expenditure or will reduce the taxes. This will shift the IS curve upward. The graphical presentation is shown below-

In the above graph, LM is vertical and the shift of IS curve from IS1 to IS2 will raise the interest level from i1 to i2 and the income level will remain the same at Y because of no change in the LM curve. The high interest rate would lead to rise in foreign capital inflow into the economy. And suppose the government uses an increase in spending as a tool for EFP this will be funded from borrowings. As a consequence of this interest rate will rise in the MM. This could result in complete crowding out of the private investment. But when lowering down the taxes is adapted as a tool of EFP it will not result in crowding out.