Question

Using the IS curve Fed rule model, explain what happens to the equilibrium values of the interest rate and output if:

a) There is an increase in T with the money supply held constant

b) A decline in G with the Fed changing the money supply enough to keep output constant

c) An increase in P with no change in government spending or taxes

Answer 1

In each graph, IS0 and LM0 are initial IS and LM curves intersecting at point A with initial interest rate r0 and output Y0.

(a) Higher tax will lower disposable income, which will decrease savings. The IS curve will shift to left, lowering both interest rate and output. In following graph, IS0 shifts left to IS1, intersecting LM0 at point B with lower interest rate r1 and lower output Y1.

(b) Lower government spending will decrease budget deficit which will reduce the demand for deficit financing (i.e. investment demand will fall). IS curve will shift leftward, lowering both interest rate and output. To keep output unchanged, Fed will increase money supply such that LM curve will shift rightward, keeping output unchanged at a further lower interest rate. In following graph, IS0 shifts left to IS1, intersecting LM0 at point B with lower interest rate r1 and lower output Y1. To keep output at Y0, Fed raises money supply and LM0 shifts right to LM1, intersecting IS1 at point C with further lower interest rate r2.

(c) Increase in price level will lower purchasing power of money, which will increase demand for money. LM curve will shift right, decreasing interest rate and increasing output. In following graph, as LM0 shifts right to LM1, it intersects IS0 at point B with lower interest rate r1 and higher output Y1.