Interaction between monetary & fiscal policy.
In the IS-LM model, monetary and fiscal policy variables are taken exogenously. While it is possible to examine the effect of each policy separately, there is a strong likelihood that the two policies are interacted which may alter the impact of the original policy change. For instance, monetary policymakers may adjust money supply in response to changes in fiscal policy, and vice versa. Now, suppose Congress increases government spending (fiscal policy). Indeed, as indicated by data, the US government spending has increased by 66% from the year of 2000 to 2008, more than doubled than the previous period. In response to the fiscal policy, the Federal Reserve can react with the followings:
a. hold money supply (M) constant
b. hold real interest rate (r) constant
c. decrease money supply (M)
d. increase money supply (M).
Using IS-LM model, analyze the effects of each of the fiscal and monetary policies above on interest rate and output. For each response, draw a graph and write a brief explanation (not more than four sentences). Use graph(s) and notations as given in class/textbook. Also, be neat in your works. Poor labeling (of graphs) can cost you significant points. WITHOUT explanations to support your graphs, you will get very minimal credit.
a. hold money supply (M) constant
b. hold real interest rate (r) constant
c. decrease money supply (M)
d. increase money supply (M).
e. Why the adverse effect on output is larger when the Fed is decreasing money supply than holding it constant? Explain.