Question

What happens to the interest rate (r) and income (Y) after the following occur? (increase or decrease)

1. Worldwide demand for German and Italian cars increases.

2.Central bank increase money supply through purchase of government bonds.

3. Households foresee better times ahead and increase consumption.

4. A new electronic payment system using smartphones becomes generally accepted for new transactions.

Answer 1

IS-LM can be used for determining the impact of several situations affecting the income and interest rate.

1. Considering the US economy, when the worldwide demand for German and Italian cars increase, the imports for the US increases. Therefore, the IS curve shifts inwards without creating any impact on the LM curve.

Here, both r and Y decline.

For a Germany or Italy, the IS would shift outwards leading to higher r and Y.

2. As the Central Bank increases the money supply, the liquidity in the economy increases. the LM curve therefore shifts outwards depicting the same. Since more money is circulating in the economy the interest rate decreases. The output, however, increases.

3. Optimism increases the demand for goods and services. Therefore, the total output and hence income increases. Also simultaneously as demand for money increases, to balance the market, the interest rate rises.

Graphically, the IS curve shifts outwards. As is evident, both Y and r increase.

4. The electronic payment system leads to a decline in the demand in the economy. The LM curve shifts outwards. This happens because at given level of income or money supply, the interest rate should decline to clear the market. This decreases r and Y increases.