Question

Suppose that Congress is going to increase government purchases on a permanent basis. Use the IS-LM/AS-AD tools to analyze the implications in the short run and in the long run. (Assume the following. Prices are completely fixed in the short run and completely flexible in the long run. Taxes remain constat. Consumption is a function of disposable income, with a constant marginal propensity to consume. Investment is a function only of interest rate. Our starting point in full equilibrium output.) 1. Use the IS-LM and AS-AD graphs to show the short run and long run equilibria following this policy. Be sure to label the axes, curves, use arrows to show shifts in curves, and mark the equilibrium points: 1 for equilibrium, 2 for the short run equilibrium, and 3 for the long run equilibrium. 2. What happens to the following variables in the short run (rise, fall, no change, can't tell): output, interest rate, investment, consumption, and real money demand. 3. What happens in the long run? For each of the variables listed in (b) above, state if it returns in the long run to its initial equilibrium value, if it is higher in the long run than its initial level, or if it is lower.

Answer 1

Initially -

The economy is in equilibrium at Pt. 1 where, both goods and money market are in equilibrium.

So, At equilibrium pt. 1,

equilibrium interest rate = i ,

  and, equilibrium output = Yn ,

and, equilibrium price = P1^e.   

In Short Run -

But, due to Fiscal Expansion (increase in govt. expenditure) IS curve will shift to the right (from IS to IS') leading to shift in equilibrium point from 1 to 2 . And, this will lead to an increase in interest rate (from i to i') and because of this AD curve will shift to the right (from AD to AD') with given AS curve, it results into increase in output (from Yn to Y') and increase in price (from P1^e to P2).

So, At equilibrium pt. 2,

price increses from P1^e to P2 , where, P2 > P1^e

and, output increases from Yn to Y' , where, Y > Yn

and, interest rate increases from i to i' , where, i' > i

and, investment will decrease.

and, consumption will increase.

AS" Р AS 3 pa P=P3 P = P2 PI AD AD Yn Y Y

LM LM 1 3 2 IS' IS Yn Y' Y

In Long Run -

Over period of time, output (Y) will return back to natural level (Yn) in medium run as expected price (Pe) increases when wage setters revive their expectation upward. Therefore, in medium run, real variables like output and real money supply remain constant at natural level and only price level increases. Thus, Stagflation (stagnation + inflation) situation will occur in the economy.