910 #
© 2014 Pearson Canada Inc.#- Using the appropriate diagram, show that fiscal policy is ineffective in the long-run.
Answer:
In a diagram like the above students must show that if the natural rate level of output is Y 1 and
the economy is in equilibrium at point 1, an increase in government spending will shift the IS 1
curve to the left to IS 2 and the economy will move to point 4 where the interest rate is higher are
i 3 from i 1 and the aggregate output is higher from Y 1 to Y 4. But since Y 4 is above the natural
rate level of Y 1 the price level begins to rise and real money balances M/P begin to fall so that
the LM curve will shift from LM 1 to LM 2. The long-run equilibrium is at point 2 where the
interest rate is i 2 higher than i 1 and aggregate output has returned to Y 1.
Diff: 3 Type: SA Page Ref: 16
Skill: Recall
Objective List: WEB CHAPTER: The ISLM Model