Question

Draw the IS-LM and AD-AS model (without Misperception Theory) to analyse the effects of each of the following on the economy in Short-run and Long-run equilibrium levels of real interest rate, output, price, employment and consumption. It is assumed that there is sticky price adjustment. Using graphs to illustrate and explain briefly.

(a) Increased investor optimistic about the figure profitability of capital investments.

(b) The government increases taxes. Do NOT take into account Ricardian Equivalence.

Answer 1

(a) Figure-1 in the document attached below illustrates the short-run and long-run impacts of the increased investor optimism about the future profitability of capital investment on AD-AS and IS-LM models. As the investor optimism regarding the potential profitability of capital investment increases, the positive profitability expectation would induce higher investment levels by the private investors and firms/companies or business organizations in the economy leading to a higher aggregate investment spending or expenditure in the economy. This would consequently lead to an increase in the aggregate demand or AD in the economy from its previous level which has been illustrated by a rightard or upward shift of the AD curve from AD1 to AD2 attributable to a higher aggregate investment or I in the goods market model depicted in the upper part of figure-1 in one of the attached documents. As a result, the real output or income increases from Y*1 to Y*2, holding the long-run aggregate supply and the short-run aggregate supply curves constant at LRAS1 and SRAS1. An increase in AD also leads to inflationary effects in the economy as indicated by an increase in the overall price level of goods and services from P*1 to P*2 in the upper part of the figure-1. Now, due to a rightard or upward shift of the AD curve from AD1 to AD2 in the goods market, the IS curve also shifts to the right or up in the lower part of figure-1 from IS1 to IS2 and holding everything else constant, an increase in the real output or income from Y*1 to Y*2 has also be depicted in the IS-LM model in the lower or below section of figure-1. Due to an upward or rightward shift of the IS curve from IS1 to IS2, observe that the equilibrium interest rate in the economy also rises from r*1 to r*2, again holding LM curve as constant or no change in the liquidity preference in the money or loanable funds market. Referring back to the AD-AS model in figure-1, the difference between Y*2(intersection between LRAS1, AD1, and SRAS1) and Y*1(intersection between AD2 and SRAS1) implies that the goods market or the economy is operating above its full-employment GDP or output level due to an increase in AD which signifies that as the aggregate investment spending has increased in the economy, the firms or companies would hire or deploy more factors or inputs of production in the production process thereby, increasing the overall short-run employment level in the economy. However, as the aggregate supply level would adjust gradually according to the increase in AD due to higher aggregate investment spending, the price level of goods and services in the economy will again restore to its original position and the goods market and economy would again readjust to its full-employment GDP or output level with consequent impact on the equilibrium interest rate in the IS-LM model. Hence, from an overall point of view long-run adjustment in the economy would stabilize or readjust all the concerned macroeconomic variables in the eventual future.

(b) Figure-2 in the attached document below depicts the impact of an increase in tax T by the government on both the AD-AS and IS-LM models. Primarily, a tax increase would reduce the personal disposable income of the consumers and households leading to a decrease in the aggregate consumption expenditure or spending in the economy or C and an increase in the personal aggregate savings level. This would consequently lead to a contraction or reduction in the AD as illustrated by a leftward or inward shift of the AD curve from AD1 to AD2 in the goods market in the upper part of figure-2. Again, holding the long-run and short-run aggregate supply curves or LRAS1 and SRAS1 as constant, this would decrease the real output or income in the goods market and economy and induce a deflationary impact as indicated by a shift in the equilibrium real output or income level and price level of goods and services from Y*1 to Y*2 and P*1 to P*2 in the upper part of figure-2. Now, the impact of reduced AD due to higher tax can also be evident in the IS-LM model depicted in the lower or below part of figure-2. As a consequence of lower AD, the IS curve shifts leftward or downward from IS1 to IS2 and holding the LM curve constant, this would lead to an equivalent or proportionate decrease in the real output or income in the IS-LM model as well, which is indicated by a shift from Y*1 to Y*2 in the IS-LAM model here. The equilibrium interest rate in the IS-LM model and the economy decreases from r*1 to r*2 due to the leftward or inward shift of the IS curve. Now, due to the reduction in the real output or income level on the goods market because of lower aggregate consumption expenditure attributable to higher tax, the goods market, and the economy experience a recessionary gap or operates below the full employment GDP level which is indicated by the difference between Y*1(intersection of LRAS1, AD1, and SRAS1) and Y*2(intersection of AD2 and SRAS1) and the overall employment level in the economy would drop as lower AD would imply lower resource or factor mobilization by the firms or companies there is no reasonable point behind increasing production level. Now, as the aggregate supply level eventually adjusts accordingly with the short-run change in the AD due to lower consumption expenditure and the without any external intervention/s, reduction in the SRAS would further lead to inflationary effects in the goods market and the economy thereby, raising the overall price level of goods and services and restoring the equilibrium level of real output or income in the economy at the long-run full employment level and readjusting the equilibrium interest rate as well.