Question

Suppose the Federal Reserve's short-run response to any change in the economy is to change the nominal money supply in whatever direction is necessary to maintain the existing real interest rate at a constant level.   
a. (4 Points) What type of monetary policy (expansionary or contractionary) would the Federal Reserve engage in if there were a reduction in government purchases? b. (3 Points) Given the Fed’s policy, what would happen in the short run (before general equilibrium is restored) to output and the real interest rate when government purchases fall? c. (2 Points) What must happen to the LM curve and the price level in order to restore general equilibrium in this case?

Answer 1

A) If there is reduction in government purchases, aggregate demand would fall in the economy because Agregate demand = Consumption + Government Spending + Investment + Exports - Imports

Fed would adopt contractionary monetary policy to reduce money supply such that rate of interest rises and reaches its initial level.

B) Due to reduction in government purchases, it would shift IS curve to its left from IS to IS1 which would result in rate of interest falling from "i" to "i1" and output level falling from "Y" to "Y1".

C) To restore initial level of interest rate, Fed would adopt contractionary monetary policy which will shift LM curve to its right raising the rate of interest from "i1" to "i" again and reduce output level further to Y2.