Answer to Question #153217 in Macroeconomics for AMINAH

Question

Assume that there is economy with increasing of government expenditure and interest rate and aggregate price level are endogenous. Please use graph to show the increasing by using:

b) IS-LM model

c) AD-AS model with the horizontal aggregate supply curve in the short run

(assume both cases initially started from natural level of income)

Answer 1

b)Rising government spending shifts the IS curve to the right The equilibrium moves from point A to point B Income increases from Y1 to Y2, interest rate - from r1 to r2.

c)According to the Keynesian point of view, an increase in public procurement will lead to an increase in output. To better understand what is happening with other variables that may interest us, remember that the basis for plotting the aggregate demand curve is the IS-LM model. In the case of an increase in government procurement, in full accordance with the logic of the IS-LM model, an increase in output occurs and at the same time an increase real interest rate. The growth in the real interest rate is associated with an increase in the demand for real money balances due to the growth of income. And this rise in the real interest rate leads to the fact that part of the crowding-out effect takes place - private investment is partly replaced by public procurement. Thus, we find that with an increase in government purchases, output increases, the real interest rate increases, investment demand decreases, and consumption of a representative consumer grows (due to an increase in real disposable income). As a result, the economy is in the state described by point B. At the same time, the price level remains unchanged, since in Keynesian models it is assumed to be fixed.