Question

Use the IS-LM graphs to answer this question. Suppose there is a simultaneous increase in government spending and reduction in the money supply. Explain what effect this particular policy mix will have on output and the interest rate. Based on your analysis, do we know with certainty what effect this policy mix will have on investment? Explain.

Answer 1

Answer:

When there is a simultaneous fiscal expansion policy (increase government spending) and a monetary contractionary policy (decrease in money supply), the interest rate (price of money) will increase. On one hand, the supply of money decreases (- money supply) and on the other the demand increases (+ spending), therefore, the equilibrium price of money will increase.

When the interest rates increase, savings will increase, while borrowing will decrease. Since the money supply is decreasing, the total level of investment will probably decrease also, since the higher savings will be offset by higher costs.