Question

Show short-term and long-term equilibrium for an economy that experiences a combination of contractionary monetary and contractionary fiscal policies. Use IS/LM, AS/AD, and Money market diagrams. Explain logic behind curve shifts/

Answer 1

Economy currently is in equilibrium with output Yn, price level P and interest rate i.

*Real Money Supply =

Nominal Money Supply(Exogenous)/Price level

Fiscal Contraction

Short run

When there is fiscal contraction it leads to a leftward shift of IS curve as shown in left panel of the diagrams. This leftward shift in IS curve leads to fall in interest rate to i2 and decrease in output to Y2. In AS-AD diagram this leads to leftward shift of AD curve leading to fall in price level to P2.

Long run

This increase in price level leads to increase in real money supply leading to right ward shift in LM curve till the point the output is back to the natural rate of Yn . This leads to further fall in interest rate to i3. In AS-AD diagram this increase in real money supply leads to rightward shift in AD curve back to normal. This brings the economy back to its long run equilibrium with price level P, output Yn and interest rate i3.

Monetary Contraction

Short run

When there is a monetart contraction, it leads to a leftward shift in LM curve leading to increased interest rate of i1 and decreased output Y1. As shown in the left panel of the diagrams. In AS-AD diagram, this will lead to a leftward shift in AD curve which will lead to fall in output level to Y1 and fall in price level to P1.

Long Run

This fall in price level will lead to an increase in real money supply which will lead to a rightward shift of LM curve till the output is back to its natural level Yn. Same will happen in AD-AS diagram , where AD will shift right till the point the output level is back to Yn and price level is back to P.

Now the economy is back in the equilibrium with output Yn, price level P and interest rate i.

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