During the Clinton administration the policy mix changed toward contractionary fiscal policy and expansionary monetary policy. This question explores the implications of this policy mix.

a) Suppose G falls and M increases and that this combination of policies has no effect on output. Show the effects of these policies in an IS-LM diagram. Be sure to label the axes and curves, and use arrows showing the direction the curves shift. Also state what happens to the interest rate and investment.

b) If instead the Fed aimed to hold the interest rate constant as a response to the contractionary fiscal policy, what would be an appropriate monetary policy strategy to achieve this goal? Show the effects of these policies in an IS-LM diagram. Be sure to label the axes and curves, and use arrows showing the direction the curves shift. Also state what happens to output.

c) This time draw the AS-AD model and explain if these policies in parts a and b have any impact on the price level and output in the short and long run.