What happens to real GDP if the government deficit spending is increased, but the Federal Reserve doesn't expand the money supply? Would the effect on real GDP be the same as if the Federal Reserve had expanded the money supply?

The possible answers are

  • that real GDP would expand just as much as if the Fed had expanded the money supply

  • that real GDP would decrease because the Fed didn't expand the money supply

  • that real GDP would expand, but not as much as if the Fed had expanded the money supply
  • interest rates would decrease
  • that real GDP would expand by more than it would have if the Fed had expanded the money supply.

I've tried just Googling the question and checking my textbook, but there doesn't seem to be anything that I found on it. I've tried thinking about it with an AD/AS model, where I figured that the AD curve would shift right, but I thought AS would catch up to it and money would just deflate, so real GDP would stay the same. However, that's not an option for the question so I'm sure I messed up somehow.

Just by process of elimination, I'm not sure about the first three, but I'm pretty sure the fourth and fifth don't make sense. Besides that, I honestly have no clue.

  • $\begingroup$ If you are using the AD AS model, perhaps you would like to use the ISLM version instead. So shift the IS right ( to denote higher spending) and then see what happens if you also raise money supply. However the correct answer will depend on whether you allow for prices to rise quickly after M rises or follow the Keynesian view that prices will not adjust quickly in the short run. Thus your possible answers can be either 1 or 3. I am assuming upward rising LM in this case. I am also assuming that the question means Fed raises money supply after the spending rise and not instead of. $\endgroup$ – erik Dec 29 '18 at 13:55

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