Use the IS-LM model to demonstrate the effects upon a closed economy of:(a) a fiscal expansion: and (b) a monetary expansion.

        If the IS curve is steeper than the LM curve, the ratio of increase in income to increase in interest rates following a fiscal expansion will be greater will be greater. The IS curve is step if investment spending is very sensitive to the interest rate. The LM curve is steep if the responsiveness of demand for money to income is high and the responsiveness of demand for money to the interest rate is low.

        The final result of this increase in government spending and subsequent increase in interest rates is that point E’’ is the new equilibrium point – this is where planned spending is equal to income and at the same time the quantity of real balances demanded is equal to the given real money stock. An increase in autonomous spending (which includes government spending) caused a shift to the right of the IS curve. For this model to work, we have to assume that price levels are constant and that firms are willing to supply whatever amount of goods are demanded at that price.

A monetary expansion, such as the United States’ Federal Reserve buying bonds to increase the stock of money, can also be analysed using the IS-LM model. If there is a monetary expansion, the LM curve will shift to the right to LM’ (as shown in figure 2). This shift will move the move the equilibrium (E) to a new point E’, where there is a lower interest rate and a higher level of income. The equilibrium level of income rises because e the open market purchase reduces the interest rate and thereby increases investment spending.

        The steeper the LM schedule, the larger the change in income. If money demand is very sensitive to the interest rate (i.e. a relatively flat LM curve), a given change in the money stock can be absorbed in the assets markets with only a small change in the interest rate. The effects of an open market purchase on investment spending would then be small. However if the demand for money is very sensitive to income, a given increase in the money stock can be absorbed with a relatively small change in the in income and the money multiplier will be smaller. The monetary policy multiplier shows how much the increase in the real money supply increases the equilibrium level of income (if fiscal policy remains unchanged).