Question

Consider the standard Keynesian ISLM model of the economy.

a.    How does a change in animal spirits which inspires fear of investment effect ISLM?
b.    How does this effect the aggregate demand and supply?
c.    What will happen to the level of output and price level in the short run and in the long run?
d.    Illustrate the above process by deriving the IS and LM before and after the shock, showing the change in aggregate demand and/or aggregate supply, and by showing the short run and long run changes of P and Y

Answer 1

(a)

Fear of investment decreases investment, which shifts IS curve leftward, decreasing both interest rate and output.

(b)

Lower investment decreases aggregate demand, shifting AD curve leftward. AS curve stays unchanged.

(c)

In short run, both price level and output will fall. In long run, lower price level increases aggregate supply, shifting AS curve rightward, intersecting new AD curve at further lower price level but initial output.

(d)

In following graph, IS0 and LM0 are initial IS & LM curves intersecting at point A with initial interest rate r0 and output Y0. When investment falls in short run, IS0 shifts left to IS1, intersecting LM0 at point B with lower interest rate r1 and lower output Y1.

In following graph, AD0, LRAS0 and SRAS0 are initial aggregate demand, long-run aggregate supply and short-run aggregate supply curves intersecting at point A with initial price level P0 and real GDP (potential GDP) Y0. Higher consumption shifts AD0 rightward, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1 in short run. In long run, SRAS0 shifts right to SRAS1, intersecting AD1 at point C with further lower price level P2 and real GDP restored to Y0.