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In the context of the IS LM model, assume an economy in which economic authorities they carry out a contractive fiscal policy
In the context of the IS LM model, assume an economy in which economic authorities they carry out a contractive fiscal policy. In view of this policy, the following is observed: . A decline in GDP. A decrease in investment. What can explain the behavior of these variables? O Faced with the contractionary fiscal policy, the central bank simultaneously made a purchase of bonds in open market. 0 The central bank does not have an interest rate target. OR All options. O The economy is in the liquidity trap.
Expert Solution
Answer: option1- Faced with the contractionary fiscal policy, the central back simulaneously made a purchase of bonds in the opwn market.
When there is fall in investment our GDP will decrease.
GDP = Investment + consumption + government spending = net exports
SO, now government do a purchase of bonds, with this there will be a increase in money supply. And when money supply increases, interest rate falls.
ANd when interest rate firms can borrow at lower rate which will increase the investment. And when investment increases GDP will increase.
In the graph below,
Firstly due to fall in GDP IS curve shifts leftward, which results in fall in output and interest rate.
Now with increased in money supply, LM curve shifts rightward. Which will increase output. At we achieve equilibrium.
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