Economics/Affect of military purchases on IS-LM
Hi there. Thanks for taking your time to read this question.
I was wondering if you might be able to assist me, I have been having trouble with a couple of problems relating to the IS-LM model that have been posed to me and I was wondering if you might be able to answer them (I already have my own answers but I am not sure they are correct).
The first question I was asked was to use IS-LM diagram to identify the short run and long run effects of real balances, consumption, investment, national income and the interest rate if there was an increase in government purchases of military goods.
The second I was for the same answer but when the case was that there had been a cut in income taxes on the country and they were launching a military attack on another country with no exit strategy
I have got my own answers I have written down but I am not sure the logic is correct, I haven't included them on this simply because both questions equate to about 3 pages long.
First, it's important to understand that the ISLM model is completely insufficient, and is used these days more as a way to illustrate the logic behind it, than anything functional. Without getting into too much depth on that issue, pay attention to what equity investors are saying next time interest rates increase - I promise you they won't be claiming that it's growing the economy This is a much more dynamic issue than the ISLM model allows for, and any conclusions drawn about the questions you're asking using this model will be frightfully inaccurate.
That being said, using this model in its intended manner, we can come to the following conclusions:
Increase in government spending on military goods will increase consumption, investments, and national income, but a decrease in interest rates, given the rightward shift in the LM curve caused by increased national liquidity as government money is injected into the household and company sectors of the economy.
A cut in income taxes would also create a rightward shift in the LM curve, since it also increases investor liquidity. The military attack would somewhat increase liquidity through government expenditures, as in the first question, but also causes capital flight as much of the value of government spending is being put into the foreign nation, or simply resulting in sunk costs from destruction and possible reconstruction, rather than contributing anything of actual value, thereby limiting the potential returns generated from those expenditures.
Again, though, this model really doesn't take into account a wide range of economic variables.