Discuss the comparative effect of monetary and fiscal policy under the IS-LM framework with diagrams

The IS-LM model is a macroeconomic model that represents the interaction of the "real" economy (IS curve) with the monetary sector (LM curve). The IS curve represents equilibrium in the goods market, while the LM curve represents equilibrium in the money market.

1. Monetary Policy: Monetary policy is represented in the IS-LM model through shifts in the LM curve. An expansionary monetary policy (e.g., lowering interest rates or increasing money supply) shifts the LM curve to the right. This is because with more money in the economy, interest rates decrease, which increases investment and income. Conversely, a contractionary monetary policy (e.g., raising interest rates or decreasing money supply) shifts the LM curve to the left.

Diagrammatically, an expansionary monetary policy would look like this:

[IS curve remains the same, LM curve shifts to the right]

The result is a decrease in interest rates and an increase in income.

2. Fiscal Policy: Fiscal policy is represented in the IS-LM model through shifts in the IS curve. An expansionary fiscal policy (e.g., increasing government spending or decreasing taxes) shifts the IS curve to the right. This is because with more government spending or less taxes, aggregate demand increases, which increases income and, consequently, interest rates. Conversely, a contractionary fiscal policy (e.g., decreasing government spending or increasing taxes) shifts the IS curve to the left.

Diagramm