Suppose Congress and the president decide to increase government purchases today, say for national defense. Assume this increase of government purchases is temporary. Explain how this affects the IS curve. How does your answer depend on the way in which the spending is financed and on the extent to which Ricardian equivalence holds?
a) First, explain what is the Ricardian equivalence?
b) Now, answer the question, using the baseline IS curve model (no multiplier).
Show the equation of the IS and the graph of the "short-term fluctuation" (X-axis) vs the real interest rate in the (Y-axis), both before and after the policy implementation. The response of the IS curve will depend on the way in which the spending is financed and on the extent to which Ricardian equivalence holds.
So, you should show how will the economy respond in each case:
1) if it is financed with an increase in current taxes or future taxes; and
2) with Ricardian equivalence and without. There are four possible cases. You should have four different graphs showing the IS curve before and after the policy for each case.