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Graphically illustrate a negative demand shock offset by lowering interest rates using the IS-MP model to...

Graphically illustrate a negative demand shock offset by lowering interest rates using the IS-MP model to keep the economy at potential GDP. Explain the process.
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Ans: When there is a negative demand shock, then the aggregate demand falls in the economy. So, output becomes less than Y* level of output. To offset the negative demand shock, the central bank will increase the money supply by lowering interest rates. People will hold more money in hand and less in bonds. So, aggregate demand rises in the economy. The MP curve will shift to right, downwards with an increase in money supply. The result is, a decrease in interest rates and increase in output level and becomes equal to Y*.

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