Question

Suppose that declines in house prices cause a large decline in household wealth.

(a) Use the IS-LM diagram and the fixed price Keynesian model to illustrate and explain the impact of this decline on the key macroeconomic variables.

(b) Use the IS-LM diagram to illustrate and explain the automatic adjustment of the economy to this event.

(c) What is the Keynesian rationale for intervention in this event?

(d) Describe how the government might respond with fiscal and/or monetary policy to help the economy in the short-run.

Answer 1

Ans ) IS shows the equilibrium in goods market while LM shows the financial equilibrium. Hence when both curve intersects then both market will clear the market i.e, the rate of interest, income will be in equilibrium in both the market. IS curve change when the price of goods changed as a result the curve shift right or left according to the situation.

In the above equation when the price of house increase the demand of house as a result the income and interest rate will also increase As shown in above figure the IS curve will shift to IS' (rightward to the original curve) and interest rate will also increase. Now the market in disequilibrium state income shown by Y in figure it will decrease to y1. As result in money market when the interest rate increase it will increase the demand for money as there is decrese in real balance (M/P )increase and this will shift the LM curve to LM' ( as shown in figure). From all the shift in curves the equilibrium will shift from E to E1.

Ans (b) Now the equilibrium income increased because of decline in price. LM curve also shift to LM' because increase in income the demand for money also increases and as a result the money supply will increase to stabilize the economy and the economy income increase to Y2 after the increase in money supply the income will increase but the rate of interest will be same as before.

Ans (c) Keynesian rationale is that the IS curve shift because of price decline. IS shift to rightward because of reduction in the price and the demand for house will increase.

Ans (d) The increase in money supply is the result of increase in income because of increase in investment in the market and because the income has increased now there is greater demand in the money market.