Question

Consider a decrease in government spending, illustrate all possible responses by the Fed using the IS-LM model. (Note that you should have three different diagrams for this question.) Explain the final outcome of each response in words. (3 points)

Answer 1

Due to a decrease in the level of government spending, the total output of the economy will decrease, So, the IS curve will shift to the left. There can be three possible outcomes by the Fed -

1)nIncrease Money supply (Ms)

2) Money supply (Ms) constant

3) Decrease Ms

In the case of 1), the LM curve will shift to the right. Assuming Ms increases by an amount that offsets the decrease in G, the real rate of interest will remain the same. The output will increase from Y1 to Y2.

In the case of 2), the Is curve will shift left so the output and real rate of interest will decrease. Ms remains constant so the LM curve is unchanged.

In the case of 3), The LM curve shifts left. Assuming Ms decrease by an amount that offsets the decrease in G, the real rate of interest will remain the same. The output will decrease from Y1 to Y2.

LM 191 1SL 192 LS