Use the following to answer questions : Figure: Fiscal Policy with a Fixed Money Supply -(Figure: Fiscal Policy with a Fixed Money Supply) Look at the figure Fiscal Policy with a Fixed Money Supply. Assume that this economy is at E₁. Now government deficit spending increases and the Federal Reserve expands the money supply. According to this model: A)real GDP might increase in the short run, but inflation can lead to a return to the original level of real GDP in the long run. B)real GDP will decrease because the government expanded deficit spending. C)real GDP will decrease, but not as much as if the Federal Reserve had contracted the money supply. D)interest rates will decrease.

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According to the model, if there is an increase in government deficit spending and the Federal Reserve expands the money supply, real GDP might increase in the short run, but inflation can lead to a return to the original level of real GDP in the long run. This is represented by the movement from point U1 to U2, then from B1 to B2, and finally back to U1.

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