Question

Consider the Keynesian adjustment process in which the price level and nominal wage are fixed in the short run.  The Keynesian theory assumes that aggregate real output will adjust to the aggregate demand following a disturbance.  For each of the following changes, what are the short-run effects on the real interest rate and output?  Use the IS-LM curve framework and aggregate supply and demand curves to help explain your reasoning when it is relevant in developing the implications of the particular disturbance.

(a)    The Federal Reserve anticipates a higher future inflation and adopts a tighter monetary policy to slow the growth rate of the money supply.

(b)    Congress passes legislation that raises the business income tax rate (τ).

(c)     A temporary decline in consumer confidence which decreases current desired consumption.

(d)    There is a current (temporary) adverse productivity shock due to an unanticipated decrease in the supply of oil.

Answer 1

In all of the following IS-LM graphs, IS0 and LM0 are initial IS and LM curves intersecting at point A with initial interest rate r0 and output (real GDP) Y0.

In all of the following AD-AS graphs, initial equilibrium is at point A where AD0 (aggregate demand) and SRAS0 (short-run aggregate supply) curves intersect with initial equilibrium price level (inflation) P0 and initial equilibrium real GDP (output) Y0.

(a)

Tighter monetart policy decreases money supply, so LM curve will shift leftward, increasing interest rate and decreasing GDP.

In following graph, LM0 shifts left to LM1, intersecting IS0 at point B with higher interest rate r1 and lower GDP Y1.

Lower money supply increases interest rate, which decreases investment. When investment decreases, it decreases aggregate demand, shifting AD curve leftward and decreasing both inflation and real GDP.

In following graph, AD0 shifts leftward to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1.

(b)

Increase in business tax decreases investment, so IS curve will shift leftward, decreasing interest rate and decreasing GDP.

In following graph, IS0 shifts left to IS1, intersecting IS0 at point B with lower interest rate r1 and lower GDP Y1.

When investment decreases, it decreases aggregate demand, shifting AD curve leftward and decreasing both inflation and real GDP.

In following graph, AD0 shifts leftward to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1.

(c)

Decrease in consumption causes IS curve to shift leftward, decreasing interest rate and decreasing GDP.

In following graph, IS0 shifts left to IS1, intersecting IS0 at point B with lower interest rate r1 and lower GDP Y1.

When consumption decreases, it decreases aggregate demand, shifting AD curve leftward and decreasing both inflation and real GDP.

In following graph, AD0 shifts leftward to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1.

(d)

Decrease in oil supply increases its price, so firms face higher input cost and decreases production. This causes IS curve to shift leftward, decreasing interest rate and decreasing GDP.

In following graph, IS0 shifts left to IS1, intersecting IS0 at point B with lower interest rate r1 and lower GDP Y1.

When oil price increases, it decreases aggregate supply, shifting SRAS curve leftward, thus increasing price level and decreasing real GDP, causing a stagflation.

In following graph, SRAS0 shifts leftward to SRAS1, intersecting AD0 at point B with higher price level P1 and lower real GDP Y1.