Question

Use the S-I model to illustrate and discuss the impact of a rise in income ( Y ) on the economy; specifically on the real interest rate, investment, savings, and consumption. Answer parts a) and b) below:

a) Show the impact of the rise in income (rise in Y ) on S-I diagram. Y ). Draw diagrams, label the figures, and clearly illustrate the impact on each variable. LABEL THE AXES & the CURVES!

b) NOW DISCUSS how the shock affected the economy, including the real interest rate, investment, savings, and consumption. Provide intuition; do not just state the changes, but discuss/explain why the changes occur using economic reasoning as done in class; make sure to explain the impact of a change in r

Answer 1

• The IS-LM model describes how aggregate markets for real goods and financial markets interact to balance the rate of interest and total output in the macroeconomy.
• IS-LM stands for "investment savings-liquidity preference-money supply.

An increase in the income will increase the money supply in the market. An increase in the money supply shifts the LM curve to the right in the short run. This moves the economy from point A to point B in the figure: the interest rate falls from r1 to r2, and output rises from Y to Y2. The increase in output occurs because the lower interest rate stimulates investment, which increases output.

Since the level of output is now above its long-run level, prices begin to rise. A rising price level lowers real balances, which raises the interest rate. As indicated in the figure, the LM curve shifts back to the left. Prices continue to rise until the economy returns to its original position at point A. The interest rate returns to r1, and investment returns to its original level. Thus, in the long run, there is no impact on real variables from an increase in the money supply.

(ii) A fall in the interest rate leads to an expansion of investment, causing equilibrium output, income and emloyment to increase as we move down along the IS curve. A fall in the real exchange rate shifts world demand onto domestic goods, increasing income at each level of the real interest rate and shifting IS to the right. An increase in rest-of-world income, or exogenous increase in consumption or investment or net exports at any given level of the real interest rate also causes the IS line to shift to the right and the equilibrium level of output, income and employment to increase.

The intuition behind the positive slope of LM is as follows: An increase in the interest rate reduces the demand for money and an increase in income increases it. To keep the demand for money equal to a constant money supply as the interest rate rises and we move along the LM curve, the level of income must increase.

An increase in the money supply holding the real interest rate constant requires a higher level of income to make the demand for money equal to that greater supply, shifting LM to the right. The combinations of income and the real interest rate at which the demand for money equals the supply now lie farther to the right. An increase in the expected inflation rate at a given level of the real interest rate increases the cost of holding money and reduces the quantity people chose to hold. This requires that the level of income rise at the given world real interest rate to bring desired money holdings back into line with the unchanged money supply and preserve asset equilibrium---the LM curve shifts to the right.

Overall equilibrium will occur where the IS and LM curves cross. In a an economy that is closed to international trade, an increase in the money supply in Figure 2 will shift LM to the right causing the interest rate to fall as the public tries to reestablish portfolio equilibrium by purchasing assets. The fall in the interest rate will cause output, income and employment to increase. The interest rate will fall and income will increase until the quantity of money demanded has increased by an amount equal to the increase in the money supply. The new equilibrium will be at point b in Figure 2.

Starting with a full-employment situation where IS and LM cross, let us assume that there is a decline in desired investment so that the IS curve shifts downward to IS'. In the short run before the price level can adjust the real interest rate will fall from r₁ to r₂ and output and income fall from their full-employment levels to Y₁ . As time passes the price level will fall, increasing the real money stock and shifting the LM curve down to LM'. As a result, the real interest rate will fall from r₂ to r₃ and income and employment will return to their full-employment levels.

The rZ line imposes on our small open economy the effect of world market conditions on the determination of the domestic real interest rate.