Question

Use the IS-LM diagram to describe the short-run effect of the following changes on national income, interest rate, price level, consumption, investment and real money balances.

a) An increase in Money Supply

b) An increase in Government Purchase

c) An increase in Taxes

Answer 1

a. An increase in money supply:

This would lead to a fall in the equilibrium interest rate in the money market and thus, would lead to a downward shift of the LM curve. At the new equilibrium, interest rate is lower and output is higher.

The LM curve shifted from the red line to the green line.

b. An increase in government purchases:

This would lead to an increase in consumption expenditure and would shift the IS curve to the right. At the new equilibrium, both output and interest rates are higher than the original levels.

The IS curve shifts from the blue line to the purple line.

c. An increase in taxes:

This would lead to a fall in consumers' disposable income and would therefore decrease consumption expenditure. This would shift the IS curve to the left and both output and interest rate will be lower at new equilibrium.

The IS curve shifted from the blue line to the purple line.