Presently many European countries are in the middle of an economic slump, where output has fallen below potential output (by a large degree in the case of some countries). Suppose one of these countries decides to follow the advice of a noted economic expert who claims what the economy needs to boost output and employment in the short-run is the passage of a properly designed government austerity package. By austerity we mean a package where the government attempts to improve the size of their budgetary deficit. The expert claims that a properly designed and executed austerity package will created beneficial changes to consumer and business confidence. We assume this country is large enough that we can easily use the closed economy IS/LM model to describe its economic conditions.

a) Draw one IS/LM diagram that depicts the initial short-run equilibrium along with any (and all) shifts in the short-run that are implied by the experts’ arguments. Explain in words how and why each curve shift has occurred. Does it seem the expert claims are reasonable or not? Explain.

b) Draw a second IS/LM curve that depicts what would occur in the short-run, if in addition to the shock in part A, agents also tend to demand more money the larger the government budget deficit. Explain in words whether this additional force works to assist or to undermine the experts’ claim.