Question

Predict, with the aid of the IS-LM and the SAS-AD models, the short-run and long-run results when consumer optimism increases.

Assume the economy is initially in long-run equilibrium at the natural real GDP.

To receive full credit make sure to do the following:

(i) Explain why each curve shifts.

(ii) Clearly label the starting equilibrium.

(iii) Clearly label at least 2 short-run equilibrium points.

(iv) Clearly label the final long-run equilibrium.

(v) What happens to the interest rate, output, price level, nominal wage, real wage in the short-run?

(vi) What happens to the interest rate, output, price level, nominal wage, real wage in the long-run?

Answer 1

i) When consumer optimism increases that means consumer confidence increases when economy expands this means when economy expands we have more consumption or expenditure by consumer which will increase agregate demand and hence our short run equilibbrium arises. Similarly this happens when consumer confidence declines this happens when economy contract and consumer expenditure declines and this will shift AD to the left and also impact IS curve as it includes agggegate demand. IS shift left when AD shift left and IS shift right when AD shift right. In case of new long run equilibrium. if we assume decline in AD this will increase SAS in the long run and if AD increase in the short run this will decrease SAS in the long run.

ii) In the graph below , you can see that first graph is for IS - LM and second is for AS - AD. IS is positively related to rate of interest and LM is inversely related to rate of interest and in the second SAS is short run aggregate supply which is upward sloping and AD is downward sloping. In the second graph i have taken Price level on the vertical axis. In this point A shows initial equilibrium where IS = LM and LRAS = SAS = AD at point A in which LRAS is long run aggregate supply which is vertical and hence point A shows long run initial equilibrium.

iii) Now in the below graphs i have shown two short run equilibrium points as B and C. B point arises when there is decline in AD at that point new AD = SRAS which is short run equilibrium point and also in case of IS - LM as shift downward in AD also lead to shift in IS downward. So B is one of the short run equilibrium point and next when there is a increase in AD that will shift AD upward and we have new short run equilibrium point as C where new AD = SRAS and similarly this shows in IS - LM model.

iv) In the below graph, we have to show longrun equilibrium . I am assuming one case only when there is a increase in AD from the previous part so we had short run equilibrium at C now to get long run equilibrium SAS will shift to the left as assuming wages increase in the longrun  as shown by SAS1 and with this we have new lonrun equilibrium point as D. which is a new long run equilibrium at this SAS1 = AD1 = LRAS