New exports are stimulated more than investment is

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Unformatted text preview: important part of that mechanism: an increase in the money supply lower the interest rate, which stimulates investment and thereby expands the demand for goods and services. Interaction between monetary and fiscal policy Consider a federal policy of eliminating the budget deficit through either a spending cut or a tax increase. The effect on the economy depends on how the Bank of Canada responds to the spending cut. If the Bank wants to hold the money supply constant, the spending cut shifts the IS curve to the left, causing falling income and interest rates (a recession). If the Bank wants to hold the interest rate constant, they must decrease the money supply. The IS curve shifted left and so did LM, holding r constant. This deepens the recession because in the first case the lower interest rate stimulates investment, but if they keep r constant investment will fall. If the Bank wants to hold income constant, it must raise the money supply and shift LM rightward to offset the leftward shift of IS. This causes a fall in the interest rate but avoids a recession. Therefore, we can see that the impact of a change in fiscal policy depends on the policy that the Bank of Canada pursues, that is, on whether it holds the money supply, the interest rate, or the level of income constant. Shocks to the IS curve are exogenous changes in the demand for goods and services. Some economists have emphasized that such changes in demand can arise from investors’ animal spirits – exogenous and perhaps self- fulfilling waves of optimism and pessimism. If firms become pessimistic about the future of the economy, the build fewer factories, and the decrease in equilibrium income caused by this validates their initial pessimism. Shocks to the IS curve can also arise from changes in demand Page 35 of 52 Jessica Gahtan Prof: Mokhles Hossain Macroeconomics ECON2000 Fall 2013 for consumer goods. If consumer confidence increases, this induces them to save less for the future and consume more today. This shift in the consumption function increases planned expenditure and shifts IS to the right, raising income. Shocks to the LM curve arise from exogenous changes in the demand for money. Suppose that demand for money increases as people become worried about the security of holding wealth in less liquid forms, a sensible worry if t...
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This test prep was uploaded on 03/28/2014 for the course ECON 2000 taught by Professor Henriques during the Fall '10 term at York University.

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