1. expand the money supply and tighten fiscal policy.
2. expand fiscal policy and leave monetary policy unchanged.
3. expand fiscal policy and appropriately reduce the money supply.
4. tighten monetary policy.
Choose the correct option.
The correct option is option 3. Fiscal expansion will shift the long-run equilibrium real interest rate up. But this will increase output and employment in the short-run if the money supply remains unchanged. To prevent output from increasing the government must contract the money supply by just enough to force the LM curve through the intersection of the new IS curve and the vertical full-employment line. This is easier said than done in practice because, as will be recalled from the earlier Fiscal Policy lesson, it is difficult to determine how big the impact of various fiscal measures will be. And, of course, the authorities cannot observe the positions and slopes of the IS and LM curves in the way that we can present them theoretically.