A fiscal expansion will tend to cause which of the following to occur? Assume the LM curve is horizontal. Select one:A.an increase in the interest rate and an increase in investmentB.a reduction in the interest rate and a downward shift in the LM curveC.no change in the interest rate and an ambiguous effect on investmentD.no change in output if the Fed simultaneously pursues expansionary monetary policy
Question
A fiscal expansion will tend to cause which of the following to occur? Assume the LM curve is horizontal. Select one:A.an increase in the interest rate and an increase in investmentB.a reduction in the interest rate and a downward shift in the LM curveC.no change in the interest rate and an ambiguous effect on investmentD.no change in output if the Fed simultaneously pursues expansionary monetary policy
Solution
The correct answer is D. No change in output if the Fed simultaneously pursues expansionary monetary policy.
Here's why:
A fiscal expansion refers to an increase in government spending or a decrease in taxes, which stimulates aggregate demand. In the context of a horizontal LM curve, which suggests that the central bank is committed to maintaining a fixed interest rate, a fiscal expansion will increase income and output.
However, if the Federal Reserve (the "Fed") simultaneously pursues an expansionary monetary policy, which involves increasing the money supply to lower interest rates, it can offset the increase in income and output from the fiscal expansion. This is because the increase in the money supply will shift the LM curve to the right, leading to a decrease in interest rates and a corresponding decrease in investment. This decrease in investment can offset the increase in income and output from the fiscal expansion, leading to no change in output.
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