Question

Consider a closed-economy IS-LM model. Assume initially the economy is at medium run equilibrium. Discuss with the help of graphs the effects of a decrease in consumer sentiment for output, interest rates and price level in the short run as well as in the medium run. Be sure to explain how the economy transitions from short run to the medium run.

Answer 1

Aggregate demand = Consumption + Investment + Government Spending + Exports - Imports

If there is lack of consumer cofidence in the economic system, tehy would consume less of the goods which will reduce the aggregate demand in the economy. It will reduce the price level from P to P1 while output level falls frm Y to Y1 in the economy and shifting the economy from point A to B.

As aggregate demand is reduced, it will shift the IS curve to its left reducing the rate of interest from i to i1 as well as output level from Y to Y1 in short run.

In medium run, to raise the aggregate demand Fed will raise the money supply in the economy which will shift the LM curve to its right. They will raise money supply such that people have more money in their hands which will rase their willingness to pay for the goods and raise the overall demand in the economy.

It will cause rate of interest to fall further to i2 and output level to rise to its initial level at Y.

In medium run, producers will respond to fallen demand as reduced demand will create inventories if producers does not reduce their supply of goods. It will take the price to its initial level of P while it reduce the output level further to Y2 level.

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We were unable to transcribe this image

Rake of Interest? um Lm. - Ev I ut ---- JE Output level