Question

Suppose the US government decreased its expenditure. What should the Fed do to

(a) hold Money supply constant,

(b) hold interest rate constant

(c) hold output constant? Use the IS/LM model to answer each case.

Answer 1

C) Hold Interest Constant

Suppose US government reduces expenditure, by IS-LM model reduction in expenditure reduces aggregate output.

( Y = C + I + G + X , Here G denotes expenditure as G decreases output decreases.)

Now, main objective of fed is to increase the output ( keeping the output constant at intial level)  but output is not in direct control hold of FED.

FED can only change money supply by changing interest rate to keep the output constant.

Hence, the objective of FED is to keep interest rate constant at intial level.

All the best.

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