Question

Suppose that there is a slump in Animal Spirits, reducing the level of investment at every interest rate. Use the IS-LM model to analyze the effect on the economy in both the short-run and the long-run. Use a well-labeled graph to illustrate. For the long run, take it as given that the Price Level will tend to fall as long as Y is less than its potential level and rise in the opposite case.

Answer 1

Aggregate demand = Consumption + Investment + Government Spending + Exports - Imports

As investment level fall at every interest rate, it will reduce the aggregate demand and shift the IS curve to its left. In short run, a fall in IS curve reduce the interest rate from "i" to "i1" and output level fall from "Y" to "Y1".

A reduction in aggregate demand in short run will reduce price from P to P1 and output level from Q to Q1 where economy fall from its potential level of output of Q.

In long run, Fed will adopt expansionary monetary policy which will raise the money supply in the economy from LM to LM1 which will reduce the rate of interest from "i1" to "i2" while it takes economy to its potential output.

A reduction in interest rate further induces producers to produce more because it reduce the cost of borrowing. It will shift the aggregate supply curve to its right from AS to AS1 and take economy to its potential output of Y*.