Question

Use the classical IS-LM model to show the effects of a temporary decrease in government purchases on the equilibrium levels of output, the real interest rate, employment, the real wage, and the price level.

Answer 1

A temporary decrease in governmental purchases leads to an income impact which reduces workforces’ labor supply. This outcomes in a fall in the full-employment output level from FE2 to FE1 as shown in graph . The fall in governmental purchases also moves the IS curve downwards and leftwards, since it augments national saving. Presuming that the movement of the IS curve is so big that it crosses the LM to the left of the Full Employment line, the level of prices must decline to get back to equilibrium at level of full employment, by moving the LM curve downwards & to the right. The outcome is a fall in output & real ROI.

Labour supply shifts outwards, leading to a rise in the actual wage & a fall in employment level.The average labour productivity increases, as employment falls though capital is fixed. Investment rises, as the real ROI falls.

In reaction to a temporary decrease in governmental purchases, the output level, the real ROI, prices , and employment fall, whereas average labour productivity & level of investment increase.