Apply a fiscal shock. Pick how the Fed responds. See three different outcomes.
Apply fiscal shock
+100
Fed reaction
ΔY +150
Δr +1.0pp
Fed holds M constant: IS shifts right. New equilibrium higher up the LM curve. Y rises by less than the Keynesian-cross multiplier amount (partial crowding out). r rises moderately.
Comparison table
Fed reaction
Δ Money supply
Δ Y
Δ r
Real-world example
Hold M
No change
Moderate ↑
Moderate ↑
Default IS-LM textbook case
Hold r
Expand to absorb fiscal expansion
Large ↑ (no crowding out)
0
Greenspan 1990s — Fed accommodated fiscal
Hold Y
Contract sharply
0 (full offset)
Large ↑
Volcker 1980s — refusing to accommodate Reagan deficits
AD-AS dynamics — supply shocks
Apply a shock to AD or SRAS. Choose the Fed response. See the short-run and long-run paths.
Shock type
Fed response (for supply shocks)
AD-AS diagram
Adverse supply shock, Fed neutral. SRAS shifts up/left. In the short run: P rises, Y falls below potential (stagflation). With no policy response, prices and wages eventually adjust, SRAS returns to original position, and Y returns to potential. Recession self-corrects, but slowly.