Answer to Question #301884 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. Explain using the diagram. (300-500 words)

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? Explain using the diagram (500 words).

(P.S: I need a detailed answer around 1000 words.)

Answer 1

1) A decline in the price level causes real money balances, M/P, to increase (if nominal money supply, M, stays constant) and the LM curve shifts to the right. There is an excess supply of real money balances and the interest rate declines to stimulate demand for real money balances. The decline in interest rate also leads to an increase in private spending (investment). Thus, income rises until the goods sector and the assets sector are in equilibrium again. The new equilibrium is at a higher level of output and at a lower interest rate. The effect of a price change (which is movement along the AD curve) on the interest rate, private spending, and output (the shift of the LM curve) is called the real balance effect.

2) Crowding effect is the situation where there is an increased interest rates leading to a reduction in private investment spending such that it dampens the initial increase of total investment spending.

In the case of substantial crowding out monetary policy is more effective.