Suppose that the government wants to stimulate GDP using fiscal policy, for example by raising G from 2,500 to 3,000. How does this affect your IS and LM curves? Where is the new intersection point? Show this in a new graph.
f) Suppose that instead of using fiscal policy, G remains constant at 2,500, but the money supply M increases from 15,000 to 18,000. How does this change your IS and LM graphs and where is the new intersection point? Draw a new IS-LM graph to answer this question. (Assume that P remains constant at 3.)
g) Suppose that monetary policy continues to expand beyond the M=18,000 level. At what level of M would interest rates reach 0? At this point, it is said that the economy reaches a liquidity trap. For values of M higher than this critical value, the IS and LM graphs intersect at a negative level of r. Since interest rates cannot be negative, however, output is no longer determined by the intersection point of the IS and LM curves. Instead, it is determined by the intersection of the IS curve with the horizontal axis, i.e., the r=0 axis
h) Now suppose that M is 30,000 and that the government increases G from 2500 to 3000. What is the effect of this fiscal expansion on Y and r? In this case, is the increase in G more or less effective (as a stimulant of output) than in part e? What is the key difference between the two cases? In addition to your calculations, show your results graphically.