Question

Suppose that the government of an economy that is in its long-run equilibrium gives out money to most of the residents. Using the IS-LM and AS-AD model, describe both the short-run effects and the long-run effects of the following changes on national income, the interest rate, the price level, consumption, investment, and real money balances. Make sure to use both words and figures.

Answer 1

Ans. This is fiscal expansionary policy of government which increases government spending. This leads to increase in consumption spending shifting the IS curve rightwards to IS’ and increasing aggregate demand shiting it from AD to AD’. This will increase real demand for money which will increase real interest rate from r to r’ increasing cost of borrowing leading to decrease in private investment. Increase in aggregate demand leads to increase in price level from P to P’ and output from Y to Y’.

In long run, increase in price causes real wages of workers to decrease leading them to demand more wages which will increase cost of production reducing aggregate supply shifting the aggregate supply curve to the left from AS to AS’ reducing output from Y’ to Y but increasing prices further to P”. This increase in price decreases real money supply increasing interest rate further to r” and decreasing real balances to L from L’. This will shift the LM curve to the left from LM to LM’ and output decreases to level Y.

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