Is output ambiguous and is the relation to investment then
My problem and answer is posted below. My question is; Is output ambiguous and is the relation to investment then
Problem: Use the IS-LM model to answer this question. Suppose there is a simultaneous increase in government spending and reduction in the money supply. Explain what effect this particular policy mix will have on output and the interest rate. Based on your analysis, do we know with certainty what effect this policy mix will have on investment? Explain.
Taking each piece independently:
An increase in government spending would be a fiscal expansion that would shift the IS curve to the right. The LM curve would not shift. With the shift right in the IS curve, output increases and the interest rate is unchanged.
A reduction in the money supply would be a monetary contraction that would increase the interest rate. The IS curve does not shift. The LM curve shifts upward representing a higher interest rate and a decrease in output.
Now looking at these happening simultaneously, we essentially combine these results and we know that
Output is unknown or ambiguous since the increase in gov. spending would increase output while the reduction in money supply would decrease output.
Interest rate would increase.
We don’t know with certainty what effect this policy mix will have on investment. The effect on investment is unknown because investment is dependent on output and interest rates. Higher interest rates imply that there is a decrease in the incentive to invest in the short run but since output is ambiguous, we’re unsure if there will be lower sales and hence lower investment or higher sales, thus higher investment. Therefore, the effect on investment is ambiguous or unknown.