# 3. Policy Effects on Expanding Economies --- ## (a) Microland: Contractionary Monetary Policy ### **Step 1: Effect in the Money Market** - **Graph**: Draw the money market with the vertical money supply ($M_s$) and downward-sloping money demand ($M_d$). - **Action**: The Federal Reserve reduces the money supply (shifts $M_s$ left). - **Explanation**: - The leftward shift of $M_s$ reduces the quantity of money available. - At the initial interest rate, money demand now exceeds money supply, causing the equilibrium interest rate ($r$) to rise. **Result:** - **Interest rate ($r$) increases.** --- ### **Step 2: Effect in Goods and Investment Markets** - **Graph**: - IS-LM diagram: LM curve shifts left (upward). - Investment Demand: Downward-sloping $I(r)$ curve; move left along the curve as $r$ rises. - **Explanation**: - Higher $r$ makes borrowing more expensive, so investment ($I$) falls. - Lower investment reduces aggregate demand, shifting the AD curve left in the goods market, lowering output ($Y$). **Result:** - **Investment ($I$) decreases.** - **Output ($Y$) decreases.** --- **Final Answer (a):** - **Interest rate rises, investment falls, and output falls.** - **Graphs:** 1. Money Market: $M_s$ shifts left, $r$ rises. 2. IS-LM: LM shifts left, $r$ up, $Y$ down. 3. Investment Market: Move left along $I(r)$, $I$ down. --- ## (b) Macroland: Contractionary Fiscal Policy ### **Step 1: Effect in the Goods Market** - **Graph**: IS-LM diagram, focus on IS curve. - **Action**: The government reduces spending or increases taxes (shifts IS curve left). - **Explanation**: - Lower government spending or higher taxes reduce aggregate demand. - IS curve shifts left, leading to lower equilibrium output ($Y$) and a lower interest rate ($r$). **Result:** - **Output ($Y$) decreases.** - **Interest rate ($r$) decreases.** --- ### **Step 2: Effect in the Money and Investment Markets** - **Graph**: - Money Market: Demand for money falls as $Y$ falls, $r$ falls. - Investment Market: Move right along $I(r)$ curve as $r$ falls. - **Explanation**: - Lower $r$ encourages more investment, but the drop in demand/output may outweigh this. - Net effect: Investment ($I$) may fall, rise, or stay unchanged depending on the sensitivity of investment to $r$ and the size of the shift. **Result:** - **Investment ($I$) likely decreases, but may partly offset due to lower $r$.** --- ### **Crowding Out?** - **Explanation:** - Crowding out refers to government spending increasing interest rates and reducing private investment. - Here, contractionary fiscal policy **does not cause crowding out**; in fact, it may lead to **"crowding in"** (lower $r$, higher private investment), but overall demand falls. --- **Final Answer (b):** - **Output falls, interest rate falls, and investment likely falls (but could rise slightly if interest rate effect is strong).** - **No crowding out occurs with contractionary fiscal policy.** - **Graphs:** 1. IS-LM: IS shifts left, $Y$ and $r$ fall. 2. Money Market: Lower $Y$ reduces demand for money, $r$ falls. 3. Investment Market: Move right along $I(r)$, possible small increase in $I$.