Policy mix in IS-LM model: Dealing with a budget deficit and unemployment in the IS-LM model
Channel: econom
Date: 24/11/2015

What is to be done with a budget deficit and unemployment in the IS-LM model?

A budget deficit implies that spending by government exceeds its revenue. To decrease this budget deficit a contractionary fiscal policy such as a decrease in government spending and/or increasing taxation needs to be implemented.
Lets take the case of a decrease in government spending.
In terms of the IS-LM model a decrease in government spending causes a decrease in the demand for goods and the level of output declines and unemployment rises. This is represented by a leftward shift of the IS curve and a new equilibrium is reached where both the interest rate and the level of output are lower. Note that on its own a contractionary fiscal policy cause a decline in the budget deficit but at the expense of an increase in unemployment.
By implementing, at the same time, an expansionary monetary policy the impact on the level of output is softened. An increase in the money supply decreases the interest rate and as the interest rate is decrease investment spending, the demand for goods and the level of output rise. In terms of our IS-LM model model this is represented as downward shift of the LM curve.
An equilibrium position can be reached where the budget deficit is lower without a corresponding decline in output.

However if the economy is in a liquidity trap an expansionary monetary policy will not have the desired results since in this case monetary policy is ineffective.