For this problem use the full IS-LM model. Start from an equilibrium. Suppose th

Question

For this problem use the full IS-LM model. Start from an equilibrium. Suppose the government and the central bank are at odds. The government wants to reduce the interest rate, while the central bank wants to keep the interest rate where it is. Suppose the government uses a fiscal policy to lower the interest rate. For the central bank a monetary contraction will help counter the effect on the interest rate, and will lead to an increase in output a monetary expansion will help counter the effect on the interest rate, and will lead to an increase in output the central bank cannot counter the effect of the fiscal policy a monetary contraction will help counter the effect on the interest rate, and will lead to a decrease in output More information is needed to answer this question

Explanation / Answer

Under IS-LM model, interest rate will be reduced by the government if IS curve shifts leftwards and this can occur either with reduction in the government spending or increase in taxation. Both these fiscal policy factors decrease the interest rate in the market. To maintain the same interest rate, there is need to shift LM curve rightwards. The rightward shift of LM curve will counter the effect of fiscal policy. Rightward shift of LM curve increases the output in the economy.

So, answer is a monetary expansion will help counter the effect on the interest rate, and will lead to an increase in output.

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