Question

Consider a closed economy, make sure to include an explanation. Using an IS-LM-FE framework analyze the consequences of the following event according to a Real Business Cylcle economist (also called a Neo-classical economist). Government spending increases temporarily.

Answer 1

IS-LM-FE framework:

IS curve: it shows equilibrium in goods market and is the relationship between investment and saving. The IS curve is downward sloping from left to right.    

LM curve: it shows the equilibrium in money market and is the relationship between demand for and supply of money. The LM curve is upward sloping.

FE curve: it shows the equilibrium in labour market and is the relationship between demand for and supply of labor in the market.

The below graph shows the equilibrium between IS-LM-FE curve at the point of intersection the economy is in state of equilibrium at E where there is full employment in the economy at Y (income level) and at R (rate of interest) .

Now suppose the government spending increases temporarily it will shift the IS curve to right and it will lead to increase in the money supply in the economy so the income level will increase to Y2 from Y as the increase in government spending will lead to increase in the aggregate demand in the economy. The new IS curve will intersect the LM curve at higher point and income level will increase it will lead to increase in demand which will further lead to increase in the price level and nominal wages. The LM curve will shift to leftwards. The new IS curve will intersect the new LM curve at point E1 at higher rate of interest and at previous income level.     

So we can see that as a consequence of increase in government spending temporarily the rate of interest and price level will increase in the economy while the income will not change.