Question

A decrease in government spending will, in the long-run, cause no change in

A. output.

• B. the real interest rate.

• C. the price level.

• D. all of the above.

• E. both (a) and (b) of the above.

Use the AD-AS framework and suppose the economy is in equilibrium at the full-employment level of output. If the Federal Reserve increases the money supply, the long-run final effect would be:

A. an increase in output.

• B. a decrease in the real interest rate.

• C. an increase in the price level.

• D. all of the above.

• E. none of the above.

According to IS-LM model, a contractionary fiscal policy (combined with an expansionary monetary policy) will cause, in the short run:

A. both output and interest rate to rise

• B. both output and interest rate to fall.

• C. output to rise and interest rate to fall.

• D. interest rate to fall but the effect on output is ambiguous.

Answer 1

Answer 1) A decrease in government spending will, in the long-run, cause no change in output because in long run output will be back at full employment level and only price level will be affected and output will be affected in the short run.

Hence option A is the correct answer.

2) when the economy is in equilibrium at the full-employment level of output. If the Federal Reserve increases the money supply, the long-run final effect would be an increase in the price level because output is at full employment level so any monetary expansion will shift the AD curve to the right and create an inflationary gap in the short run it leads to increase in the price and output in the short run. As a result in the long run AS curve will shift upward and this will continue until new equilibrium is attained where employment remains at full employment level and at level only price will increase, output will remain unchanged.

Hence option C is the correct answer.

3) According to IS-LM model, a contractionary fiscal policy (combined with an expansionary monetary policy) will cause, in the short run interest rate to fall but the effect on output is ambiguous because as a contractionary fiscal policy and expansionary monetary policy interest rate will fall and output will be ambiguous as shown in the diagram because of contractionary fiscal policy IS curve will shift to the left and because of expansionary monetary policy LM curve will shift to the right. Hence interest rate will fall and effect of output will depend on the magnitude of both the curves.

Hence option D is the correct answer.

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