In the economy of Togo, the price level is exogenously determined.

In the economy of Togo, the price level is exogenously determined. As a consequence, theeconomy is well represented by an IS-LM model. The economy is currently in equilibrium atpoint A with output level Y0 and interest rate r0.The government of Togo has identified output level Y0 to be preferred to all other levels ofoutput. It knows, however, that exogenous shocks to the Togo economy will cause output tovary from output level Y0 from time to time.The central bank of Togo has announced it will always maintain a fixed money supply. That is,the money supply is exogenously determined while the interest rate is endogenously determined.The government, in charge of setting taxes (T) and levels of government spending (G), is tryingto decide between one of two policy options. Option A is to set G and T exogenously and allowthe interest rate (r) to vary endogenously. Option B is to allow G and T to be determinedendogenously so as to hold the value of the interest rate constant. Which policy should thegovernment of Togo choose?To answer this question, first assume that Togo is struck by exogenous shocks to money demandthat cause the LM curve to sometimes be to the right, and sometimes be to the left, of theposition shown in the diagram. Which policy option is preferred?Now assume that Togo is struck by exogenous shocks to investment that cause the IS curve tosometimes be to the right, and sometimes be to the left, of the position shown in the diagram.(There are no shocks to the position of LM.) Which policy option is preferred in this case?

 

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