Question

For each of the following shocks, use the Keynesian cross, the market for real money balances and IS-LM graphs to predict the effects of the shock on income, the interest rate, consumption, and investment. Do not forget to label your graphs properly and to explain how the economy adjusts towards the new equilibrium in each case. In addition, explain what the central bank should do to keep income at its initial level in each case.

3. A best-seller personal finance book convinces the public to increase the percentage of their income devoted to saving.

Answer 1

Increase in saving decreases consumption expenditure, which in turn decreases aggregate expenditure (AE), shifting the AE curve downward. This decreases equilibrium income.

In following graph, planned aggregate expenditure (PAE) and real GDP (Y) are measured vertically and horizontally respectively. Initial Equilibrium is at point A where 450 line intersects initial aggregate expenditure curve PAE0, with equilibrium GDP Y0 and planned aggregate expenditure E0.

When consumption decreases from C0 to C1, the PAE0 line shifts down to PAE1. New Equilibrium is at point B where 450 line intersects new planned aggregate expenditure curve PAE1, with lower equilibrium GDP Y1 and lower planned aggregate expenditure E1.

Lower consumption decreases the demand for money, which shifts money demand curve leftward, decreasing interest rate. To keep interest rate unchanged, central bank has to decrease money supply so that money supply curve shifts leftward, intersecting new money demand at initial (higher) interest rate.

In following graph, MD0 and MS0 are initial money demand and supply curves, intersecting at point A with initial interest rate r0 and quantity of money M0. When money demand decreases, MD0 shifts left to MD1, intersecting MS0 at point B with lower interest rate r1.

Lower money demand will shift the LM curve rightward, decreasing interest rate and increasing output. To keep output unchanged, central bank decreases money supply, which increases interest rate and decreases investment, thus reducing aggregate demand and output.

In following graphs, IS0 and LM0 are initial IS and LM curves intersecting at point A with initial interest rate r0 and output Y0. When money demand decreases, LM0 shifts right to LM1, intersecting IS1 at point B with lower interest rate r1 and higher output Y1.