Question

1.The LM curve can shift to the right if there is an increase in the supply of money or a fall in the price level. In which case does this represent a movement along the aggregate demand curve and in which case does this represent a shift of the aggregate demand curve? Use the IS-LM diagram and Aggregate demand curve in your explanation.

2. Examine how changes in monetary policy and changes in fiscal policy affect the economy in the short and long-run. Suppose the government wants to stimulate the economy by either expansionary monetary policy or expansionary fiscal policy. With the use of the IS-LM model and AD-AS model, explain the similarities and differences between these two policies in the short and long run. Illustrate your reasoning graphically and explain. For simplicity, you can assume SRAS is a horizontal line. You can also assume that the economy begins at a point where the LRAS, the SRAS and the AD intercept.

Answer 1

In the figure, upper panel shows IS LM curves with interest rate on Y axis and Output on X axis. IS is the initial IS curve and LM is the initial LM curve. E is the initial equilibrium where i0 is the initial equilibrium interest rate and Y0 is the initial equilibrium output. In the lower pane, an AD curve is downward sloping from left to right. There is price on Y axis and Output on X axis. Downward sloping AD shows that there is negative relationship between price and AD.

• Suppose there is fall in price, this will cause money supply to rise in the economy as a result LM shifts to right as LM'. This cause new equilibrium to arise at E' where new Equilibrium output rises fromY0 to Y1. Simultaneously in the lower panel there is a downward movement along AD because price decrease and Output rises.

• Suppose there is an increase in the supply of money, it will cause rightward shift of LM to LM'. Now new equilibrium is at E' and at the same price new output is Y1. Here as price remain same but Output increases it means there is a rightward shift of AD.