Question

1. Using the IS-LM graphs, explain what will happen to output and the interest rate if...

1. Using the IS-LM graphs, explain what will happen to output and the interest rate if consumers suddenly become pessimistic and decrease their consumption spending at all levels.

2. Using the IS-LM graphs, explain what will happen to output and the interest rate if financial panic leads to an increase in the demand for money.

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Answer #1

In each graph, IS0 and LM0 are initial IS and LM curves intersecting at point A with initial interest rate r0 and output Y0.

(1) A fall in consumption spending will decrease aggregate demand and output, shifting IS curve leftward, lowering both interest rate and output. In following graph, IS0 shifts left to IS1, intersecting LM0 at point B with lower interest rate r1 and lower output Y1.

(2) Increase in demand for money will shift money demand curve rightward, increasing interest rate and quantity of money. As a result, LM curve will shift leftward, increasing interest rate and decreasing output. In following graph, LM0 shifts left to LM1, intersecting IS0 at point B with higher interest rate r1 and lower output Y1.

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