Question

4. In the IS-LM model, explain how does an increase in aggregate price level affectequilibrium income. If you use any diagram, label your axes and curves clearly

Answer 1

Increase in the aggregate price level will reduce the real money balances which is M/P. This decrease in real money supply shifts the LM curve to the left to LM'. New equilibrium is attained at e' where interest rate is higher at i2 and equilibrium income is lower at Y2.

Intuitively, decrease in money supply leads to increase in interest rate to encourage people to hold more bonds than to money. Higher interest rate reduces demand for money and hence goods. This results in lower equilibrium income.