Question

Exhibit: Policy Interaction

Based on the graph, starting from equilibrium at interest rate r₃, income Y₂, IS₁, and LM₁, if there is an increase in government spending that shifts the IS curve to IS₂, then in order to keep output constant, the Federal Reserve should _____ the money supply, shifting to _____.

Select one:

a. increase; LM₂

b. decrease; LM₃

c. increase; LM₃

d. decrease; LM₂

Answer 1

correct answer is (D) decrease LM₂

Suppose the government increases its purchases of goods and services from G₀ to G₁. This increases the aggregate demand for goods and the IS curve shifts up and to the right. The new level of demand is determined at intersection of IS₂ and LM₁ curves at E₃ . At the higher level of government spending the aggregate demand for goods is greater than the aggregate supply of goods, Y₂. Firms will see their inventory of goods fall and they will respond by increasing prices. Also, workers will bargain for higher nominal wages to keep their real wage constant. As overall prices and wages rise, the LM curve will shift up and to the left and the real interest rate will rise. As r increases, interest sensitive spending (consumption and investment) falls as we move along the IS₂ curve toward the new general equilibrium at r₂. At the new equilibrium, output is again Y₂ but the real interest rate and the price level are higher. Also, the higher amount of government spending has crowded out some private consumption and investment expenditure due to the higher real interest rate. The end result of the increased level of government spending is no increase in real output but the composition of demand has changed: more government spending and less private spending.