Draft Agenda: Advice the finance minister on how to 1. 2. 3. 4.

achieve a high level of current output and employment achieve a high level of growth (i.e. increase in level of investment) control inflation try to control/eliminate the fiscal / Budget deficit

Lets consider the case of contractionary fiscal policy i.e. the Government Spending decreases so as to move the IS curve left. Here, we assume that the Tax rules remain unchanged. The following are the changes in short run. 1. 2. 3. 4. 5. IS Curve shifts left and this causes the aggregate demand curve to shift left from AD 0 to AD1 for the same price level P0 Now for the same price level P0, there is a greater supply and lesser demand. This causes the prices to reduce to the level P1. As there is a reduction in the price level, the supply of real balances, which is the ratio of M/P, increases. This results in the shift in the LM curve to the right i.e. from LM 0 to LM1. The new LM curve LM1 cuts the new IS curve IS1 at the reduced interest rate r2. Hence, in the short run, the following are the effects,

1. 2. 3. 4.

Interest rate falls from r0 to r1. This causes investment to increase and hence the growth increases. Current Output decreases from Y1 to Y0 and this result in the increase in unemployment. This is the trade-off here. Price level decreases from P0 to P1. This reduces the inflation. As there is a decrease in Government spending, keeping taxation rules constant, fiscal deficit decreases.

The following are the changes in the long run. 1. The aggregate supply equation can be written as, Y=YN + a (P Pe). The reduction in the price level in the short run causes the expected price level to decrease and hence the firms renegotiate the contracts that were already made as the cost of production is now lesser compared to the earlier price levels. This shifts the supply curve to the right, i.e. AS0 to AS1. The shift happens until the point where newly shifted aggregate demand curve, AD1, meets the long run aggregate supply. This further reduces the price level from P 1 to P2. This price fall further causes the rightward shift in the LM curve to the level LM 2. Hence, the new LM curve LM2 cuts the new IS curve IS1 at the reduced interest rate r2. Hence, in the short run, the following are the effects, 1. Interest rate falls from r1 to r2. This causes further improvement in the investment and the growth improves further. 2. Current output reaches back the original level. This, of course, is an increase in the output from the original short run level of output of Y0 to Y1. Hence, there is an increase in employment. 3. Price level further falls from P1 to P2. This further reduces the inflation. 4. Fiscal deficit is reduced as there was a reduction in the Government spending initially.

2. 3. 4. 5. 6.