Question

2.)Use the IS-LM diagram to describe the short-run and long-run impact on national income, the price level, and the interest rate of (Illustrate your answers with graphs.):

a)An increase in the money supply.

b)An increase in government purchases.

c)An increase in taxes.

Answer 1

a) An increase in money supply will shift money supply curve rightwards which reduces the rate of interest. This induces investment and consumption spending so that aggregate demand shifts right and real GDP and price level are higher. This will result in shifting LM curve to the right which reduces interest rate and increase real GDP.

In the long run, as price level rises, nominal wages are adjusted in proportion so that cost of production rises. Aggregate supply shifts leftwards and real GDP is reduced/returned to its long run level

b) An increase in government spending would stimulate aggregate spending so there is a new goods market equilibrium when IS shifts right. In loanable funds market, this increased spending will result in budget deficit so deficit is financed which shifts demand function rightwards and interest rate is increased. Some of the private investment is crowded out. This implies aggregate demand shifts right and real GDP and price level are higher.

In the long run, as price level rises, nominal wages are adjusted in proportion so that cost of production rises. Aggregate supply shifts leftwards and real GDP is reduced/returned to its long run level

c) This has entirely opposite effect of a government spending increase. This would depress aggregate spending so there is a new goods market equilibrium when IS shifts left. In loanable funds market, this decreased spending will result in budget surplus which shifts supply function rightwards and interest rate is decreased. This implies aggregate demand shifts left and real GDP and price level are lower.

In the long run, as price level falls nominal wages are adjusted in proportion so that cost of production falls. Aggregate supply shifts rightwards and real GDP is increased/returned to its long run level