Graphical show and discuss how the following fiscal policy shifts the IS curve and show its effect on income and interest rate in the closed economy
A.Decreas in government expenditure
B.Decrease in tax
C.Show the effects of the above policy in the open economy case; both in the fixed and flexible rate
A. Decrease in government expenditure:
When government expenditure decreases, it leads to a leftward shift in the IS curve. This is because lower government spending reduces aggregate demand in the economy, leading to lower output and income at each level of interest rates.
The decrease in government expenditure leads to a decrease in the equilibrium level of income (Y) and a decrease in the equilibrium interest rate (r) in the closed economy.
B. Decrease in tax:
When taxes decrease, it leads to a rightward shift in the IS curve. This is because lower taxes increase disposable income which in turn increases consumption and aggregate demand in the economy.
The decrease in taxes leads to an increase in the equilibrium level of income (Y) and an increase in the equilibrium interest rate (r) in the closed economy.
C. Effects of the above policies in the open economy:
1. Fixed exchange rate regime:
In a fixed exchange rate regime, the exchange rate is fixed to a specific value. In this case, the fiscal policy changes will have limited effects on the exchange rate. However, the decrease in government expenditure will lead to lower income and output in the economy, while the decrease in taxes will lead to higher income and output.
2. Flexible exchange rate regime:
In a flexible exchange rate regime, the exchange rate is determined by market forces. In this case, the fiscal policy changes will have a more pronounced effect on the exchange rate. The decrease in government expenditure will lead to a decrease in income and output, as well as a depreciation of the currency. The decrease in taxes will lead to an increase in income and output, as well as an appreciation of the currency.