Question

Consider a closed economy where firms fear that sales will soon decline and therefore reduce investment (demand shock), although they are not currently facing lower than usual sales and there have been no changes in the interest rate.

1. Use the linear specification of the IS-LM model and its graphical representation to explain what is the effect of the demand shock on the equilibrium level of output assuming that the central bank does not change the monetary policy following the shock.

B. How would your answer change assuming, instead, that the central bank takes monetary policy decisions to avoid changes in the level of output following the shock?

Note: LM is horizontal

Answer 1

Part 1) Let us assume that the economy is currently operating at point E with output level of Y1 and interest rate of r1. Now, it is given that firms have reduced investment. This acts like an exogenous event which will shift the IS curve downward from IS1 to IS2. As a result, the income level will decline to Y2 and interest rate will decline to r2.

Part 2) Now, it is given that the Central Bank uses monetary policy measure to avoid changes in the level of output following the decline in the investment. So, the Central Bank can increase the money supply to achieve this objective. An increase in the money supply shifts the LM curve downward from LM1 to LM2. For a given level of income an increase in the money supply will result in people increasing their speculative balances. As a result, the price of bonds will increase while their yield (interest rate) will fall. So, while the output level will again reach the initial level of Y1, the interest rate will further decline to r3.

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