Question

Using the IS/LM and AS/AD framework, discuss what would happen to r, y, and the price level (p) in both the short and long run. Show the IS/LM and AS/AD graphs for full credit.

1. There is an exogenous decrease in money demand.

2. Consumer confidence increases

3. When discussing the classical model I believe there was some discussion of the effects of a balanced-budget increase in government expenditures (∆G=∆T). Now let’s consider these in a Keynesian model

Suppose that the government increases its expenditures, ∆G>0, but raises taxes by the same amount in order to keep the budget balanced such that ∆G=∆T

4. Suppose government expenditures (G↑) are increasing due to a new foreign intervention abroad (insert name of whichever country it might happen to be in this time) at the same time the Fed is implementing a tighter monetary policy (M↓).

Answer 1

a) If investment does not depend on the interest rate, the IS curve is vertical.
The IS curve represents the relationship between the interest rate and the level of income
that arises from equilibrium in the market for goods and services. That is, it describes the
combinations of income and the interest rate that satisfy the equation Y = C(Y-T) + I(r) +
G. If investment does not depend on the interest rate, then nothing in the IS equation
depends on the interest rate; income must adjust to ensure that the quantity of goods
produced, Y, equals the quantity of goods demanded, C + I + G. Thus, the IS curve is
vertical at this level.   
Monetary policy has no effect on output, because the IS curve determines Y. Monetary
policy can affect only the interest rate. In contrast, fiscal policy is effective: output
increases by the full amount that the IS curve shifts.
b) If money demand does not depend on the interest rate, the LM curve is vertical.
The LM curve represents the combinations of income and the interest rate at which the
money market is in equilibrium. If money demand does not depend on the interest rate,
then we can write the LM equation as M/P = L(Y). For any given level of real balances
M/P, there is only one level of income at which the money market is in equilibrium. Thus,
the LM curve is vertical.   
Fiscal policy now has no effect on output; it can affect only the interest rate. Monetary
policy is effective: a shift in the LM curve increases output by the full amount of the shift.
c) If money demand does not depend on income, the LM curve is horizontal.
If money demand does not depend on income, then we can write the LM equation as M/P
= L(r). For any given level of real balances M/P, there is only one level of the interest
rate at which the money market is in equilibrium. Hence, the LM curve is horizontal.
Fiscal policy is very effective: output increases by the full amount that the IS curve shifts.
Monetary policy is also effective: an increase in the money supply causes the interest rate
to fall, so the LM curve shifts down.
d) If money demand is extremely sensitive to the interest rate, the LM curve is
horizontal.

The LM curve gives the combinations of income and the interest rate at which the supply
and demand for real balances are equal, so that the money market is in equilibrium. The
general form of the LM equation is M/P = L(r,Y). Suppose income Y increases by $1.
How much must the interest rate change to keep the money market in equilibrium? The
increase in Y increases money demand. If money demand is extremely sensitive to the
interest rate, then it takes a very small increase in the interest rate to reduce money
demand and restore equilibrium in the money market. Hence, the LM curve is (nearly)
horizontal.
If money demand is very sensitive to the interest rate, then fiscal policy is very effective:
with a horizontal LM curve, output increases by the full amount that the IS curve shifts.
Monetary policy is now completely ineffective: an increase in the money supply does not
shift the LM curve at all.
2) Use the IS-LM diagram to describe the short-run and long-run effects of the following
changes on national income, the interest rate, the price level, consumption, investment,
and real money balances.
a) An increase in the money supply.
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.