Answer to Question #225094 in Macroeconomics for Sara

Question

The economy is at full employment. Now the government wants to change the composition
of demand toward investment and away from consumption without, however, allowing ag-
gregate demand to go beyond full employment. What is the required policy mix? Use an IS-
LM diagram to show your policy proposal.

Answer 1

Fiscal policy can lead to an increase in Aggregate Demand and a rise in real Gross Domestic Product. The increase in economic growth will cause increased demand for workers, providing employment and reducing unemployment.

The fiscal expansion will raise the demand for goods and services. This greater demand leads to increases in both output and prices.

The impact of fiscal policies in the IS-LM model depends also on the interest elasticity of the transaction demand for money.

In the diagram below, as the LM curve becomes flattened due to the interest elasticity of the transactions demand money, a shift of the IS curve to the right increases Y from Y₀ to Y₂ which is greater than the increase from Y₀ to Y₁ when the LM curve is less flat, i.e., when interest elasticity of transactions demand money is zero.