Question

Suppose the government increases government expenditure while at the same time the Federal Reserve decides to increase the federal funds rate. explain what will happen. Also include a graph if possible

Answer 1

Government has increased government expenditure. This will increase aggregate demand. Aggregate demand curve will shift to the right. Price level and real GDP will be higher in the short run

Federal reserve has increased federal funds rate. This will decrease the amount of reserves and the ability of commercial banks to generate loans. reduce liquidity means reduced money supply and this increases interest rate. Investment is reduced and this decreases aggregate demand. aggregate demand curve shifts to the left and this indicates that in the short run price level and real GDP will be lower

Together these events will negate each other so that aggregate demand remains more or less unchanged. It first shifts out then shift inside so that there is no change in its position.