Question

Suppose that there is a slump in Animal Spirits, reducing the level of investment at every interest rate. Use the IS-LM model to analyze the effect on the economy in both the short-run and the long-run. Use a well-labeled graph to illustrate. For the long run, take it as given that the Price Level will tend to fall as long as Y is less than its potential level and rise in the opposite case.

Answer 1

Reduction of investment shifts IS curve leftward, decreasing both interest rate and output in short run. In long run, lower interest rate decreases the opportunity cost of holding money, which increases the demand for money. LM curve shifts leftward, increasing interest rate to initial level but at further lower output.

In following graphs, IS0 and LM0 are initial IS and LM curves intersecting at point A with initial interest rate r0 and output Y0. Lower investment shifts IS0 leftward to IS1, intersecting LM0 at point B with lower interest rate r1 and lower output Y1. In long run, higher money demand shifts LM0 left to LM1, intersecting IS1 at point C with initial interest rate r0 and further lower output Y2.