Question

Use the Keynesian IS-LM Model to analyze the effect of the following on interest rates, employment and price level. Differentiate between the effects in the SR and LR :

1.An increase in consumer confidence, as consumers expect their incomes to be higher in the future

2.Financial deregulations allow banks to pay a higher interest rate on checking accounts

Answer 1

Case 1 (Increase in Consumer Confidence)

Short-Run: In the short-run, the aggregate supply curve (AS) is upward sloping, while the aggregate demand curve (AD) is downward sloping in both the short-run as well as long-run.

Increase in the consumer confidence will result in the shift of AD curve outward to the right from AD₁ to AD₂. Similarly, the IS curve will also shift outward to the right from IS₁ to IS₂. For a given level of interest rate, the increase in income due to the shift of the IS curve will result in increased demand for money for transaction purposes. So, people will start to withdraw money from speculative balances to finance their transaction needs. To keep the money market in equilibrium, the interest rate will rise from R₁ to R₂. Though increase in the interest rate will dampen investment demand, it will not be enough to completely negate the increased demand. As a result, the total income will increase from y₁ to y₂.

Increased output and income will result in increased employment in the short-run.

The shift of the AD curve will cause the price level to rise from P₁ to P₂.

However, in the long-run the supply curve is vertical so, there will be no change in the employment level.

But the price level will increase. Increased price level will cause the interest rates to increase as the increased price level will reduce the real money supply in the economy. People will start to withdraw money from speculative balances to finance their transaction needs. In order to keep the money market in equilibrium, the interest rate will rise.

Case 2 (Financial Deregulations resulting in Higher Interest Rate on Checking Accounts)

In the short-run, the higher interest rate on checking accounts will result in the shift of AD curve backward to the left from AD₁ to AD₂. This is because the increase in the interest rate will result in people putting more money in accounts rather than using it for transaction purposes.

This will reduce the aggregate demand in the economy. Similarly, the IS curve will also shift backward to the left from IS₁ to IS₂. This will cause a reduction in the income level. For a given level of money supply, reduction in the income will result in reduced transaction demand for money. This will translate into people putting a higher amount in speculative balances. To keep the money market in equilibrium, the interest rate will decline from r₁ to r₂. Though a decrease in the interest rate will cause the investment demand to rise, it will not be enough to completely negate the decline in demand. As a result, the total income will decline from y₁ to y₂.

However, in the long-run the supply curve is vertical so, there will be no change in the employment level.

But the price level will decrease. Decreased price level will cause the interest rates to decline as the decreased price level will increase the real money supply in the economy. People will start to put more money into speculative balances. In order to keep the money market in equilibrium, the interest rate will fall.