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Using the IS-LM model combined with the AD-AS model, show and explain the effects in the...

Using the IS-LM model combined with the AD-AS model, show and explain the effects in the SR and LR from a decrease in the money supply - assuming nothing else exogenous changes. Be certain to explain how and why variables change and include graphs.

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Answer #1

Decrease in money supply shifts the LM curve leftward to LM'. This results in increase in interest rate to i'. Increase in interest rate leads to decrease in investment spending that shifts the AD leftward to AD'. e' is the new short run equilibrium where output is lower and price level is lower too.

In long run AS curve shifts rightward to AS' because wages decrease with decrease in output below full employment. Long run equilibrium reaches at e'' where price level decreases even more and output increases back to initial level Y*.

lower price level increases the real money balances which shifts the LM' back to LM. Interest rate and output are back to original level.

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