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Decrease in government spending shift the IS downwards leading to decrease in interest rates. Low interest rates attracts more investments, hence increasing from 53.64 to 67.38
The four quadrant diagram can be used to solve for the IS curve. The curve is used to show the equilibrium output and interest rate that produces equilibrium in the product market. The function i+ g is a decreasing function of interest rate. When interest rate is high at the level i1, then investment is discouraged and hence the amount of income generated is low at the point y1.
When interest rate falls from i1 to i2, the level investment in the economy increases, hence increasing income from y1 to y2. This helps us get the IS curve which shows interest rates and incomes level that produce equilibrium in the product market.
The lm curve shows the relationship between the income and interest rates that produces equilibrium in the money market. This can be assessed by changing prices. If the prices of the goods increase, the real money balances are affected. Assuming that prices increase from the level that produces income, which corresponds to the i1, the money supply will reduce. The result is that the money demand will exceed the money supply and, hence, people will convert the money held for speculative purposes to money for transactions, which will reduce interest rates.
The importance of the GDP in a country is that it represents the productivity of the country. It is used as an indicator for the standard of living for the citizens within a country. It also forms a base for government in its collection of revenue. It is used to show the government effort in collecting taxes by relating it to the tax raised. It is also an indicator of how the government is performing at the aggregate level. This helps to tell when the country is in boom or recession and it is used as guide in the demand control policies.
The treasury is the component of government that uses the monetary policies. This is done by controlling the amount of money that is in circulation by adjusting the interest rates through the operation of the discount window to the financial institutions. The measures may also include increasing the mandatory deposits, when the government wants to decrease the amount of money in circulation as a way of contraction monetary policies.
When interest rates are high, less money is borrowed for investment by the business and individuals within a country. This helps in reducing the aggregate demand and, hence, reduces the inflation, which normally exist when the aggregate demand is high. The government is also able to achieve similar results by open market operations, which involves buying and selling of the government securities such treasury bills and bonds.
As a way to manage the aggregate demand in a country, the government may opt to use the fiscal policy, which involves making use of taxation and the government expenditure. When taxes are reduced they encourage production and the national income increases. This is done when the government is executing an expansionary monetary policy.
5. When out of recession and the need is to increase employment, the policies to be employed must be aimed at encouraging investments. This can only be achieved if the interest rate is reduced. However, if this will be characterized by increasing demand, then the excess demand for money market results in rising interest rates again making the efforts ineffective. To solve the problems, we need to come up with policy mix which will not increase the output level as interest rates decrease.
If the country is not in recession, the government through its agents, such the central bank should be very keen if it wants to increase employment. This is because there will be inflation in the country, the resultant effect of an increase in output, which would reduce employment. A policy mix works perfectly to affect this. An expansionary monetary policy would help increase investment by lowering the interest rates. This results from the shift in the lm curve from lm to lm’. This would encourage investment by lowering interest rates from i to i’. To prevent increase in output, the fiscal policy should also be put in place so that to maintain output at y. lm and is should move towards the same direction.