Question

17. Use the IS/LM model to predict the effects of each of the following shocks on income, the interest rate, consumption, and investment. Explain and illustrate your answers. Assume price level is constant and the economy is closed.

a. The Fed reducing the money supply

b. The government raising government expenditures and taxes by the same amount.

Answer 1

The IS-LM model, which stands for "investment-savings" (IS) and "liquidity preference-money supply" (LM) is a Keynesian macroeconomic model that shows how the market for economic goods (IS) interacts with the loanable funds market (LM) or money market. It is represented as a graph in which the IS and LM curves intersect to show the short-run equilibrium between interest rates and output.

a. The Fed reducing the money supply

The LM curve, the equilibrium points in the market for money, shifts for two reasons: changes in money demand and changes in the money supply. If the money supply decreases, ceteris paribus, the interest rate is higher at each level of Y, or in other words, the LM curve shifts left. That is because at any given level of output Y, less money means a higher interest rate. (Remember, the price level doesn’t change in this model.)

Higher interest rates tend to moderate economic growth. Higher interest rates increase the cost of borrowing, reduce disposable income and therefore limit the growth in consumer spending.

The graph given below will help you understand this better.

The IS curve, by contrast, shifts whenever an autonomous (unrelated to Y or i) change occurs in C, I, G, T, or NX. Following the discussion of Keynesian cross diagrams when C, I, G, or NX increases, the IS curve shifts right and when these factors decrease, the IS curve shifts to left.

The graph given below shows this concept.

b. The government raising government expenditures and taxes by the same amount.

An increase in government spending shifts the IS curve to the right, and the economy moves from point A to point B, as shown in the figure below. In the short run, output increases from Y to Y2, and the interest rate increases from r1 to r2.

The increase in the interest rate reduces investment and “crowds out” part of the expansionary effect of the increase in government purchases. Initially, the LM curve is not affected because government spending does not enter the LM equation. After the increase, output is above its long-run equilibrium level, so prices begin to rise. The rise in prices reduces real balances, which shifts the LM curve to the left. The interest rate rises even more than in the short run. This process continues until the long-run level of output is again reached. At the new equilibrium, point C, interest rates have risen to r3, and the price level is permanently higher.

Refer the graph below to understand better.

An increase in taxes reduces disposable income for consumers, shifting the IS curve to the left, as shown in the figure. In the short run, output and the interest rate decline to Y2 and r2 as the economy moves from point A to point B.

Initially, the LM curve is not affected. In the longer run, prices begin to decline because output is below its long-run equilibrium level, and the LM curve then shifts to the right because of the increase in real money balances. Interest rates fall even further to r3 and, thus, further stimulate investment and increase income. In the long run, the economy moves to point C. Output returns to Y, the price level and the interest rate are lower, and the decrease in consumption has been offset by an equal increase in investment.

Refer to the graph below to understand better.