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Exhibit: Policy Interaction
-(Exhibit: Policy Interaction) Based on the graph, starting from equilibrium at interest rate r₃, income Y₂, IS₁, and LM₁, if there is an increase in government spending that shifts the IS curve to IS₂, then in order to keep output constant, the Federal Reserve should _____ the money supply shifting to _____.

Question

Use the following to answer questions :
Exhibit: Policy Interaction

-(Exhibit: Policy Interaction) Based on the graph, starting from equilibrium at interest rate r₃, income Y₂, IS₁, and LM₁, if there is an increase in government spending that shifts the IS curve to IS₂, then in order to keep output constant, the Federal Reserve should _____ the money supply shifting to _____.

Quizplus · Accepted Answer

In order to keep output constant after an increase in government spending that shifts the IS curve to IS₂, the Fed should decrease the money supply shifting the LM curve to LM₃. This is because the increase in government spending leads to an increase in the demand for money, which in turn leads to an increase in interest rates. By decreasing the money supply and therefore increasing interest rates, the Fed can offset the initial increase in government spending and keep output constant.

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