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According to the following question, it seems as though cutting back on government spending increases the money supply (the answer is C).

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The only possible explanation I can think of is that in the second fiscal year, the government continues to spend, but this time it spends less while not changing tax revenue ("In the absence of offsetting factors"), hence the MS still grows but the following fiscal year's deficit has reduced.

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The government cuts public spending but continues to "run a deficit by borrowing from the central bank."
This is the polite way to say "increase yearly the money supply by an amount equal to the government's deficit".

So the money supply will also increase in the second year, albeit by a smaller amount than before. But increase it will.

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Cutting government expenditures will lead to an increase in national saving. Thus, saving increases in goods market and IS curve decreases in IS-LM model. In long run, money supply will increase to adjust the output level back to full employment output level. Assumption: No change in tax rate.

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  • $\begingroup$ by decreasing the IS curve I presume you mean it shifts leftwards. Could you elaborate on the part where you said "Cutting government expenditures will lead to an increase in national saving" and also "money supply will increase to adjust the output level back to full employment ", e.g. how this comes about. $\endgroup$ – user98937 Apr 1 '17 at 14:03

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