Question

Consider an economy that begins in long-run equilibrium. Suppose that there is a wave of pessimism that reduces investment demand at any given real interest rate. That is, suppose that the investment demand curve shifts down and to the left. Use the IS-LM diagram and the aggregate supply - aggregate demand diagram to show how this shift down of the investment demand curve affects the interest rate, income, investment, the price level, consumption, and the supply of real money balances in both the short run and the long run. (Note: You only need to present and discuss the IS-LM and AS-AD diagrams; you do not need to present analysis in any other diagrams.)

Answer 1

Let us see first what happens in the short run

We must note that as investment spending declines it lead to decrease in the IS curve the reason is IS curve is associated with the goods market equilibrium amd aggregate spending. Thus IS curve shifts down and we can clearly observe that a new equilibrium is achieved from E⁰ to E1

A fall in IS curve also leads to fall in aggregate demand thus AD curve also shifts downward from AD0 to AD1.

Thus in the first figure in short run we can observe that it leads to a fall in output from Y0 to Y1 and a fall in interest rates from i0 to i1. Moreover if we observe AD-AS curves it leads to fall in output from Y0 to Y1 and a fall in price level from P0 to P1. Thus a new equilibrium is achieved. We must note that there is no change in AS curve as investment spending has no effect on supply side.

Moving on to the long run story we must note that in the long run as said by the classical economists AS curve is vertical rather than upward slopping. This is beacuse they say that any of the demand side factor has no effect on the output levels. Only the supply side factors has a real effect on output. We can see this diagramatically that as there is a decline in investment spending, the IS curve shifts leftward and a fall in output and interest rate is there in short run. A fall in output also leads to decline in AD but it leads to only a fall in price levels. It has no real effect on output or any of the demand side factors. Moreover AS curve stays put.

Find attached the diagram for your reference