Question

Because of the ongoing pandemic, output has declined below its long-run equilibrium. The government is then interested in pushing output back to its original level. Using the Keynesian Cross and IS-LM, demonstrate how output and the real interest rate changes from the short-run to the long-run if the government implements policy that raises output back to its full-potential.

Answer 1

If output have declined below its full potential level, there occurs a recessionary gap in the economy which reduce the overall price level and real GDP level in the economy.

If government adopts an expansionary fiscal policy by raising its spending and reduce taxes such that people have more money to spend on goods on services, it will result in rise in aggregate demand in the economy. A rise in aggregate demand will shift the IS curve to its right from IS to IS1 in short run which result in rise in rate of interest from "i" to "i1" and output level rising from Y to Y1.

A rise in aggregate demand curve in short run will shift aggregate demand curve to its right from demand to new demand which will result in rise in price level from P to P1 and output level rising from Y to Y1.

In long run, Fed will adopt expansionary monetary policy to lower the rate of interest in the economy which will shift the LM curve to its right from LM to LM1. It will lower the rate of interest to its initial position in long run while raise the output level further to Y2.