To raise investment while keeping output constant the

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To raise investment while keeping output constant, the government should adopta loose monetary policy and a tight fiscal policy, as shown in Figure 12-21. In thenew equilibrium at point B, the interest rate is lower, so that investment is high-er. The tight fiscal policy—reducing government purchases, for example—offsetsthe effect of this increase in investment on output.b.The policy mix in the early 1980s did exactly the opposite. Fiscal policy wasexpansionary, while monetary policy was contractionary. Such a policy mix shiftsthe IScurve to the right and the LMcurve to the left, as in Figure 12-22. The realinterest rate rises and investment falls.
116Answers to Textbook Questions and ProblemsABYrInterest rateIS1Income, outputr1r2Y1LM2LM1IS2Figure 12-21Income, outputY1r2r1IS2IS1LM2LM1BAYrInterest rateFigure 12-22
6.a.An increase in the money supply shifts the LMcurve to the right in the short run.This moves the economy from point A to point B in Figure 12-23: the interest ratefalls from r1to r2, and output rises from Yto Y2. The increase in output occursbecause the lower interest rate stimulates investment, which increases output.Since the level of output is now above its long-run level, prices begin to rise.A rising price level lowers real balances, which raises the interest rate. As indicat-ed in Figure 12-23, the LMcurve shifts back to the left. Prices continue to riseuntil the economy returns to its original position at point A. The interest ratereturns to r1, and investment returns to its original level. Thus, in the long run,there is no impact on real variables from an increase in the money supply. (This iswhat we called monetary neutralityin Chapter 5.)b.An increase in government purchases shifts the IScurve to the right, and theeconomy moves from point A to point B, as shown in Figure 12-24. In the shortrun, output increases from Yto Y2, and the interest rate increases from r1to rThe increase in the interest rate reduces investment and “crowds out” part of theexpansionary effect of the increase in government purchases. Initially, the LMcurve is not affected because government spending does not enter the LMequa-tion. After the increase, output is above its long-run equilibrium level, so pricesAggregate Demand I: Applying the ISLMModeI117ABISYrInterest rater1LM2Y= Income, outputLM1YY2r2Figure 12-23CBAYrInterest rater3r2r1IS1IS2LM2LM1Income, outputY= YY2Figure 12-242.Chapter 12YY
begin to rise. The rise in prices reduces real balances, which shifts the LMcurveto the left. The interest rate rises even more than in the short run. This processcontinues until the long-run level of output is again reached. At the new equilibri-um, point C, interest rates have risen to r3, and the price level is permanentlyhigher. Note that, like monetary policy, fiscal policy cannot change the long-runlevel of output. Unlike monetary policy, however, it can change the compositionof output. For example, the level of investment at point C is lower than it is atpoint A.c.

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