Question

Using IS-LM, graph and explain the effects of a decrease in wealth. Make sure to include the Money graph and the Keynesian Cross.

Answer 1

(I) IS-LM Model

A decrease in consumer wealth will decrease consumption expenditure. This shifts the IS curve leftward, which decreases both interest rate and output.

In following graph, IS0 and LM0 are initial IS and LM curves intersecting at point A with initial interest rate r0 and output Y0. Decrease in consumption spending shifts IS0 leftward to IS1, intersecting LM0 at point B with lower interest rate r1 and lower output Y1.

(II) Keynesian Cross

When consumption falls, the consumption function shifts downward and aggregate expenditure (AE) line shifts downward, decreasing equilibrium output.

In following graph, initial equilibrium is at point A where initial planned aggregate expenditure line PAE0 intersects 45⁰ line with equilibrium aggregate expenditure E0 and output Y0. Lower consumption shifts consumption function downward, from C0 to C1, which shifts the PAE line downward to PAE1, intersecting 45 line at point B and decreasing equilibrium output to Y1 and decreasing aggregate expenditure to E1.

(III) MD-MS

Decrease in output will decrease money demand. This shifts money demand curve leftward, reducing interest rate.

In following graph, MD0 and MS0 are initial money demand and supply curves intersecting at point A with initial interest rate r0 and quantity of money Q0. As money demand falls, MD0 shifts left to MD1, intersecting MS0 at point B with lower interest rate r1.