Question

For each of the following changes, what happens to the real interest rate and output in the very short run, before the price level has adjusted to restore general equilibrium? (a) Wealth rises. (b) Money supply rises. (c) The future marginal productivity of capital increases. (d) Expected inflation declines. (e) Future income declines.

Answer 1

In following graph, interest rate (r) and output (Y) are measured vertically and horizontally respectively. IS0 and LM0 are initial IS and LM curves intersecting at point A with initial interest rate r0 and initial output Y0.

(a) Increase in wealth will increase consumption, which will increase output, shifting IS curve rightward. This will increase both interest rate and output. In following graph, as IS0 shifts right to IS1, it intersects LM0 at point B with higher interest rate r1 and higher output Y1.

(b) Increase in money supply will shift LM curve rightward, decreasing interest rate and increasing output. In following graph, as LM0 shifts right to LM1, it intersects IS0 at point B with lower interest rate r1 and higher output Y1.

(c) Increase in future marginal productivity of capital will increase business investment, shifting IS curve rightward. This will increase both interest rate and output. In following graph, as IS0 shifts right to IS1, it intersects LM0 at point B with higher interest rate r1 and higher output Y1.

(d) A decrease in expected inflation decreases current consumption (since consumers want to consume in future at lower price), which will decrease output, shifting IS curve leftward. This will decrease both interest rate and output. In following graph, as IS0 shifts left to IS1, it intersects LM0 at point B with lower interest rate r1 and lower output Y1.

(e) A decrease in future income decreases current consumption (since consumers expect a decrease in real wealth), which will decrease output, shifting IS curve leftward. This will decrease both interest rate and output. In following graph, as IS0 shifts left to IS1, it intersects LM0 at point B with lower interest rate r1 and lower output Y1.