Use the following to answer questions: -(Figure: Fiscal Policy with a Fixed Money Supply) Refer to Figure: Fiscal Policy with a Fixed Money Supply. Assume that this economy is at E₁. Now government deficit spending is increased, but the Federal Reserve does NOT expand the money supply. According to this model: A) real GDP will expand just as much as if the Federal Reserve had expanded the money supply. B) real GDP will decrease because the Federal Reserve did not expand the money supply. C) real GDP will expand, but not as much as if the Federal Reserve had expanded the money supply. D) interest rates will decrease.

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In this model, an increase in government deficit spending without a corresponding increase in the money supply will lead to an increase in interest rates, as government borrowing increases. This increase in interest rates will cause a reduction in investment spending and a decrease in aggregate demand. As a result, real GDP will expand, but not as much as if the Federal Reserve had expanded the money supply.

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