Consider the closed-economy model.
(a) Suppose the economy is initially in long-run equilibrium with Y = Y¯ , r = ¯r, and P = P1. Draw IS-LM and AD-AS diagrams showing this equilibrium.
(b) Suppose the economy is then hit by an adverse supply shock, which causes P1 to jump up to P2 > P1. Using Keynesian cross and money market diagrams, explain what will happen to the IS and LM curves in the short run as a result of this shock.
Initially the equilibrium will look like following
After the supply shock, the Aggregate Supply (AS) curve will shift upward to the left side from AS to A1S1. As a result, the price level will increase from P1 to P2. Increase in the price level will reduce the real money supply in the economy. Because of this the LM curve will shift upward to the left from LM to L1M1.
Shift in the LM curve will cause interest rate to increase to r1. This is because reduction in the real money supply will cause people to withdraw money from speculative balances to finance their transaction needs. As a result, the interest rate need to increase in the money market to keep it in equilibrium.
Increase in the interest rate will cause investment demand to decline. This is because the borrowing cost of the firms has now increased.
Reduction in the investment demand will cause income to decline to Y1.
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