Question

suppose the US government decrease its expenditure. What should the fed do to (a) hold money supply constant, (b) hold interest rate constant and (c) hold output constant? Use the IS/LM model to answer each case.

Answer 1

In each of the following graphs, IS0 & LM0 are initial IS & LM curves intersecting at point A with initial interest rate r0 and output Y0.

When government decreases expenditure, IS curve will shift leftward, decreasing both interest rate and output. In each graph, IS0 shifts left to IS1, intersecting LM0 at point B with lower interest rate r1 and lower output Y1.

(a)

Fed has to take no action to keep money supply constant. The graph stays as follows.

(b)

To hold interest rate constant, Fed has to decrease money supply, which will shift LM0 leftward to LM1, intersecting IS1 at point C with same initial interest rate r0 and further lower output Y2.

(c)

To hold output constant, Fed has to increase money supply, which will shift LM0 rightward to LM1, intersecting IS1 at point C with lower interest rate r1 and same output Y0.