Question

Draw the graphs by hand. There are directions for submitting the assignment on Canvas.

1. On an AS‐AD and IS‐LM graph, show the effects of a decrease in investor confidence. Assume that the economy was originally in general equilibrium (mark this point A). Show the short‐run effects of the decrease in investor confidence on the graph, marking the short‐run equilibrium B. Finally, describe how the economy adjusts to the long run, show this on your graph, and mark the long‐run equilibrium C

. A. Relative to the initial equilibrium, what happens to output, the interest rate, and the price level in the short run?

b. Relative to the initial equilibrium, what happens to output, the interest rate, and the price level in the long run?

c. How would your answer change if this asked for a Classical analysis?

Answer 1

A. The intial equilibrium in the economy occurs at point A. A decrease in investor confidence will reduce aggregate expenditure in the economy which will reduce aggregate demand in the economy and thus shift the IS and AD curve leftwards to IS' and AD' and new equilibrium occurs at point B in both graphs.

B. This increases unemployment rate and reduces bargaining power of workers which reduces real wage rate and thus reduces cost of production and shifts the SRAS curve rightwards to SRAS' and new long run equilibrium occurs at point C.

C.a.In the short run, price level, interest rate and output has decreased relative to their initial position.

b. In the long run, it can be seen that output has reached to its initial full employment level and prices and interest rates have decreased in the economy.

c. In the Classical case, fall in investor confidence is a demand side variable and thus it will only impact price level and will have no impact on output and interest rate in the economy.