Answer to Question #317613 in Macroeconomics for CYNTHIA MBOYA

Question

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

Answer 1

If the government wants to maintain the aggregate level while shifting the GDP towards investment without affecting consumption, it must implement restrictive fiscal policy and expansionary monetary policy.

As a result of restrictive fiscal policy, personal income taxes would rise, or transfer payments would drop, reducing spending and aggregate demand. The IS-LM curve will move to the left, causing production and interest rates to fall. The government can undertake expansionary monetary policy to increase output to its original level. The government can use expansionary monetary policy to restore production to its preceding stage, which will cause the LM curve to move to the right, causing the interest rate to fall further, encouraging investment and, as a result, aggregate demand. If the junction of the new IS and LM curves is at the same income level as before, the interest rate cut has encouraged investment expenditure to the point that it has precisely offset the fall in consumption.

IS-LM diagram: