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Assume that an economy is experiencing simultaneous equilibrium in both the product market and money market. Furthermore, assume the MPC is currently around a normal level of 0.65 and the sensitivity of real money demand to also around a normal level. Based on this information, answer the following questions:
a) Using the AD-AS model and IS-LM model illustrate the impact of an expansionary fiscal policy. Label the initial points in both diagrams as A and the new points following the policy change as B.
b) What is meant by the term crowding out? In your answer also explain the implications of crowding out for the macroeconomy.
c) If the MPC rises to 0.8 and also the sensitivity of real money demand to changes in the income rises well, use the IS-LM model to illustrate the impact of an expansionary fiscal policy. Label the initial point prioer to the fiscal policy as A and the new point following the expansionary policy as B.
d) With reference to the diagrams you have prepared in parts a) and c) explain the reasons that underly differences in policy effectiveness.
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