Question

For this question, specify what happens in the money market, goods market and labor market, when appropriate (use IS-LM diagrams and AS-AD diagrams when necessary).

1. Explain using graphs and words why and how the AD curve shifts when money supply increases.

2. Explain using graphs and words why and how the AD curve shifts when there is an increase in the government spending.

3. Explain using graphs and words why and how the AD curve shifts if there is an increase in autonomous consumption (recall that this is the share of consumption that does not depend on disposable income. So with our linear consumption function C = Co + Cl(Y - T) autonomous consumption is Co).

4. Explain using graphs and words why and how the AS curve shifts in the short run (when expected price level is fxed) and medium run (when expected price level is equal to the equilibirum price level) if there is an increase in markups.

5. Explain using graphs and words why and how the AS curve shifts in the short run and medium run if there is an increase in unemployment benefts.

Answer 1

1. An increase in the money supply shifts the AD curve to the right. Intuitively, when supply of money increases, the LM curve shifts to the right, as people need to have higher income to come back to equilibrium in the financial market (from poin E to point F). The IS curve doesn't change, which further implies that for any given price level, equilibrium output is higher. Hence, AD curve shifts to the right.

2. AD curve shifts to the right. The increase in government spending shifts the IS curve to the right, but LM curve remains the same when price is fixed. Hence, for any given price level, the equilibrium output is higher, resulting in a higher aggregate demand.

3. Autonomous consumption leads to an increase in the consumption function, which further results in a rightward shift of the IS curve. The argument of the AD curve will shift to the right is similar as in part 2.

4. AS curve shifts to the left. In the short run, expected price level is fixed. Higher markup results in higher prices for any level of output. Then because expected price level gradually adjusts upward, workers ask for a higher nominal wage, which further increases price level. Hence, in the medium run, AS curve shifts further to the left.