Question

Assume the economy is at full employment. Use the IS-LM/ AD-AS model to show the short-run and long-run impacts of a positive demand shock such as an increase in business confidence and investment spending on: the real interest rate (r), real GDP (Y), unemployment (U), consumption spending (C), the nominal money supply (M), the price level (P) and the real value of the money supply(M/P). You must present properly labeled (IS-LM and AD-AS diagrams to show the SR and LR effects. Initial equilibrium points should be labeled “A”; short-run equilibrium points should be labeled “B”; and the LR should be labeled “C”. Also, present individual time graphs such as the graphs I use in class to show the impacts on EACH of these variables over time. Again use the “A”, “B”, “C” convention.

Answer 1

The followiing figure shows the impact of positive demand shock such as an increase in business confidence and investment spending on various economic variables.

In the figure, the initial equilibrium is at point A where the AD-AS and IS-LM curves intersects each other, corresponding to the Price level P0 and interest rate r0. Now due to a positive demand shock, the AD curve shifts to AD1 and intersects the AS curve at point B, corresponding to a higher price level P1 and higher consumption spending Y1. Now, due to increase in Aggregate demand and consumption spending, the level of investment in the economy increases to IS1, intersecting the LM curve at point B corresponding to a higher interest rate r1. In short run, GDP increases, unemployment decreases, consumption spending increases, the nominal money supply remains constant, the price level increases, and the real value of money supply increases.

Now, in longrun, the Aggregate Supply also increases and the AS curve shifts to AS1 and intersects AD1 at point C, corresponding to initial price level P0 and higher output level Y0'. Hence, the LM curve also shifts to LM1 and intersects the IS1 curve at point C at initial interest rate r0 and a higher GDP level Y0'. In long run, the real interest rate is at initial level, real GDP increases, Unemployment decreases, consumption spending increases, the nominal money supply increases, the price level is at initial level, the real value of money supply remains constant.