Question

Considering the Classical analysis of the IS-LM, what are the short- and long-run impact of a decline in government expenditure? Explain the effect on real wages, real interest rate, output, and other aggregate macroeconomic variables. Clearly state any assumption you might need to answer this question. Plese provide graphs to support your answer.

Answer 1

A decrease in government expenditure reduces total output in the economy, shifting the IS curve to the left, as shown in the figure. In the short run, output and the interest rate decline to Y2 and r2 as the economy moves from point A to point B.

Initially, the LM curve is not affected. In the longer run, prices begin to decline because output is below its long-run equilibrium level, and the LM curve then shifts to the right because of the increase in real money balances. Interest rates fall even further to r3 and, thus, further stimulate investment and increase income. In the long run, the economy moves to point C. Output returns to Y, the price level and the interest rate are lower, and the decrease in consumption has been offset by an equal increase in investment.