Answer to Question #301124 in Macroeconomics for Wasim Alam

Question

1. Discuss, using the IS-LM model, what happens to interest rates as prices change along a given AD schedule.

2. What is crowding out, and when would you expect it to occur? In the face of substantial

crowding out, which will be more successful—fiscal or monetary policy?

Answer 1

1. If nominal money supply M remains constant, a decrease in the price level causes real money balances, m/p to increase and the LM curve to shift to the right. Interest rate is falling to encourage demand for real money balances because there is excess supply of them. Decrease in interest rates leads to an increase in private spending as well

2. Crowding out is a phenomenon that occurs when increased government involvement in a sector of the market economy substantially affect the remainder of market either on supply or demand

It occurs when a large government increases its borrowing and sets in motion a chain of events that results in the curtailing of private sector spending.

b. In case of substantial crowding out monetary policy is more effective. If the vertical of LM curve is provided then there is an expansionary fiscal policy used then the best way to overcome crowding out is to use expansionary monetary policy.