Question

1. According to the IS–LM model, what happens in the short run to the interest rate, income, consumption, and investment under the following circumstances? Be sure your answer includes an appropriate graph.

a. The central bank decreases the money supply.
Effect of the shock:
Interest rate:
Income:
Consumption:
Investment:

b. The government increases government purchases and taxes. The increase in taxes is twice as big as the increase in government purchases.
Effect of the shock:
Interest rate:
Income:
Consumption:
Investment:

Answer 1

(a) Decrease in Money supply will result in LM to shift Leftward. Because of Leftward shift to LM curve interest rate will increase and Aggregate Output or Income will decrease. Because of Increase in interest rate investment will decrease. Also you can say that increase in interest rate will result in People saving more and hence consumption decreases. Hence we have the following result:

Interest rate: Increases
Income: Decreases
Consumption: Decreases
Investment: Decreases

(b)

IS equation is given by:

Y = (1/(1 - c))( A)

Where A = Autonomous expenditure and c = MPC also Note that A = G - T + Z

where Z represents some other autonomous spending.

Hence As increase in Tax(T) is Twice of G Hence for any interest rate Y will decrease. Hence IS will shift to the left.  

Because of Leftward shift to IS curve interest rate will decrease and Aggregate Output or Income will decrease. Because of decrease in interest rate investment will increase. Also C = C_o + c(Y - T) and as T increases C will decrease . Hence we have the following result:

Interest rate: Decreases
Income: Decreases
Consumption: decreases
Investment: Increases