Use the classical IS-LM model to show the effects of a temporary decrease in government purchases on the equilibrium levels of output, the real interest rate, employment, the real wage, and the price level.
What will be an ideal response?
The decrease in government purchases reduces workers' current or future taxes, causing them to reduce their labor supply. The leftward shift of the labor supply curve reduces equilibrium employment and increases the real wage. The reduction in employment shifts the FE line to the left. In addition, the reduction in government purchases shifts the IS curve down and to the left. Assuming that the IS curve shifts more to the left than the FE line, the price level will have to decline to shift the LM curve down and to the right to restore general equilibrium. Overall, the level of output declines, the real interest rate declines, employment declines, the real wage rises, and the price level declines.
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