Question

Suppose the US government decrased its expenditure. What should the Fed do to (a) hold Money supply constant, (b) hold interest rate constant and (c) hold output constant? Use the IS/LM model to answer each case.

Answer 1

The US government decreased its expenditure. This would lead to a leftward shift in the IS Curve.

a) To hold money supply Constant, fed should do nothing. Because a decrease in government spending doesn't have any impact on the money supply. So the fed should do nothing.

b)Shift in IS curve to the left tends to Decrease the interest rate. To hold the interest rate constant, fed should decrease the money supply and pursue a contractionary monetary policy. This would lead to a leftward shift in the LM Curve which would restore the interest rate at the initial level.

c) Leftward shift in the IS curve due to Decrease in Government expenditure, would tend to reduce the output. To restore the output at the initial level or hold it constant, the fed would have to pursue Expansionary Monetary Policy and Increase the money Supply. Increasing the money supply would lead to a rightward Shift in the LM Curve. This would hold the output constant.