Figure 352 Fiscal Policy with a Fixed Money Supply 55 Use th

Figure 35-2: Fiscal Policy with a Fixed Money Supply

55. Use the “Fiscal Policy with a Fixed Money Supply” Figure 35-2. 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

e.

real GDP will expand by more than it would have, if the Federal Reserve had expanded the money supply

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
e.	real GDP will expand by more than it would have, if the Federal Reserve had expanded the money supply

Interest rate, r Aggregate price level, P MS SRAS P2 P1 E2 MD2 AD2 AD MD1 Nominal quantity of money, M Y1 Y2 Y Real GDP

Solution

The right answer is option B. real GDP will decrease because the Federal Reserve did not expand the money supply

Explanation: If the deficit spending of the government increases, the demand for money will grow. However, if the money supply is fixed, increased demand for money will drive the interest rate upward. The higher interest rate will drive down private investment. Therefore, real GDP will decrease.