Question

2. Assume the economy is initially in a short-run equilibrium at a level of output below the natural rate. a. Use the IS-LM model to graphically illustrate: i) how the economy will adjust in the long-run if the no-policy action is taken. ii) the long-run equilibrium if fiscal policy is used to return the economy to the natural rate of output. b. Explain how investment, the interest rate, and the price level differ in the new long-run equilibrium in the two cases.

Answer 1

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Question:

i).Answer:

The economy is initially in a short-run equilibrium at a level of output below the natural rate. It means real output is below potential level where interest rate is low. Here the economy is below the natural rate at the equilibrium point E2 where interest rate and out level are below potential level. At the this level AD will be lower that will decrease price level so, lower price level will increase real money supply and LM curve shift left from LM to LM1 and the economy will reach at the natural rate at the equilibrium point E3.

ii).Answer:

The economy is initially in a short-run equilibrium at a level of output below the natural rate. It means real output is below potential level where interest rate is low. Here the economy is below the natural rate at the equilibrium point E2 where interest rate and out level are below potential level. At the this level AD will be lower that will decrease price level. when the govenment will increase spending (expansionary fiscal policy) then IS curve will shift right to IS3 and it will increase price level because increasing spending will increase income level and increasing income level will increase AD. Increase AD will increase pricel level and out put. When price level will increase it will decrease real money supply and LM curve shift left from LM1 to LM2 and the economy will reach at the natural rate at the equilibrium point E3.

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