In 2009, President Obama with Congressional approval increased government spending and decreased lump-sum taxes in response...

In 2009, President Obama with Congressional approval increased government spending and decreased lump-sum taxes in response to the financial crisis.
1. Graph and explain what happens in both the ISLM model and the ADAS model (with the upward sloping SRAS curve) in the short run. Be sure to discuss real output, real interest rate and the price level in your answer.
2. Graph and explain what happens in the long run if the Fed does not change monetary policy. Be sure to discuss real output, real interest rate and the price level in your answer. You may use your graph from part a.
3. Fill in the table based on your answers to a. and b.

Indicate if the variable increases, decreases or does not change. Compare to the initial equilibrium.
	Short run	Long run
Real output
Real interest rate
Price level
Consumption
Investment

Solutions

Expert Solution

All the above listed are fiscal measures to boost aggregare demand, hence the Ad curve will shift to the right

In short run, there is increase in output and an increase in interest rate as shown in ISLM curve. Real output and real interest rate rises in the short run as there is no sudden change in price levels. So, there is no inflation and hence no change in price level in short run

AS-AD:

Now, assuming that the economy started in the long run, we see that output is beyond full employment level. So, prices will strat increasing now, so that there is a shift along the new AD curve. AD':

So, we see that output retuns to initail level with a much higher increase in price. On the ISLM fornt, an increase in price means that the real money supply is falling, so the LM curve will move backwards. Also, an increase in interest rate means that there is some reduction in investment so IS curve shift to the left as well:

So we find that output has fallen back to original position, with an increase in nominal interest rates.

The following table summarises:

	Short run	Long run
Real output	Increase	Does not change
Real interest rate	Increase	Does not change
Price level	Does not change	Increase
Consumption	Increase	Increase
Investment	falls	falls

Rahul Sunny answered 1 week ago

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