Consider the AD/AS model built from the IS/LM. The economy was operating at full employment, but it is suddenly hit by a negative demand shock in the form of a decrease in planned investment at each level of the real interest rate.
a. Show the impact of the negative demand shock in the Keynesian cross diagram and in the IS/LM graph.
b. Show what will happen in the Keynesian cross diagram and in the IS/LM graph if the government decides to increase spending in order to contrast the negative demand shock. Assume that the increase in government spending successfully bring output back to the full employment level.
c. Compare the initial full employment equilibrium (before the negative demand shock) with the new long run equilibrium after the government policy intervention. Is the level of investment different? Is the level of consumption different?