Question

Show what happens to interest rate, output, prices and wages as

i. Government spending decreases within a general equilibrium framework

ii. Money Supply decreases within a general equilibrium framework

iii. Autonomous consumption (or autonomous investment) decreases within a general equilibrium framework

Answer 1

The effects are shown using IS-LM & AD-AS general equilibrium framework.

In following IS-LM graphs, IS0 and LM0 are initial IS and LM curves intersecting at point A with initial interest rate r0 and output Y0.

In following AD-AS graphs,, initial equilibrium is at point A where AD0 (aggregate demand) and SRAS0 (short-run aggregate supply) curves intersect with initial equilibrium price level P0 and initial equilibrium real GDP Y0.

(i)

Decrease in government spending will decrease output, shifting IS curve leftward, decreasing interest rate and output.

In following graph, IS0 shifts left to IS1, intersecting LM0 at point B with lower interest rate r1 and lower output Y1.

Decrease in government spending will decrease aggregate demand, shifting AD curve leftward, decreasing price level and real GDP. Wage rate decreases.

In following graph, lower government spending shifts AD0 leftward, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1.

(ii)

Decrease in money supply will shift money supply curve to left, shifting LM curve leftward, increasing interest rate and decreasing output.

In following graph, LM0 shifts left to LM1, intersecting IS0 at point B with higher interest rate r1 and lower output Y1.

Increase in interest rate will decrease investment spending, which will decrease aggregate demand, shifting AD curve leftward, decreasing price level and real GDP. Wage rate decreases.

In following graph, lower investment spending shifts AD0 leftward, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1.

(iii)

Decrease in autonomous spending will decrease output, shifting IS curve leftward, decreasing interest rate and output.

In following graph, IS0 shifts left to IS1, intersecting LM0 at point B with lower interest rate r1 and lower output Y1.

Decrease in autonomous spending will decrease aggregate demand, shifting AD curve leftward, decreasing price level and real GDP. Wage rate decreases.

In following graph, lower government spending shifts AD0 leftward, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1.