Question

Use the IS-LM model to predict the short-run effects of each of the following shocks on income, the interest rate, consumption, and investment. In each case, explain what the Bank of Canada should do to keep income at its initial level. For each of these four shocks, (1) shift the appropriate curve in the IS-LM graph to reflect how the economy will respond to the shock; (2) indicate the impact of the shock on consumption, income, interest rate, and investment by placing each in the appropriate category of increase" or "decrease", and (3) identify the Bank of Canada's proper policy response to maintain income at its initial level. a. After the invention of a new high speed computer chip, many firms decide to upgrade their computer systems. Firms Upgrade Computer Systems Interest Rate (in %) 0 2 4 6 8 10 12 Income (in billions of $) 14 16 18 20

Answer 1

1) After new high speed computer chip, many firms decides to upgrade their computer chip which is kind of an investment. As investment and aggregate demand have positive relationship with each other, it will raise the overall aggregate demand. A rise in aggregate demand shifts IS curve to its right from IS to IS1 while LM curve remains the same.

Interest Rate Output y ,

It will increase: Interest rate and Income

It will decrease: Investment (high rate of interest raises cost of borrowing for investors) and Consumption (high rate of interest induces people to save more money)

To maintain Income, Fed must reduce the money supply such that LM curve shifts to its left and economy reaches at its initial level of income.

2) A wave of credit card fraud induces people to make transactions in cash. It will raise the demamd for money which will shift the LM curve to its left from LM to LM1.

Caps Lock 5 € 6 Interest Rote IS yr y Output

It will increase: Interest rate

It will decrease: Income, Investment (high rate of interest raises cost of borrowing for investors), Consumption (high rate of interest induces people to save more money)

To maintain Income, Fed must raise the money supply such that LM curve shifts to its right and economy reaches at its initial level of income.

3) As savings rises, consumption falls which reduces the aggregate GDP. It will shift the IS curve to its left from IS to IS1.

It will increase: Consumption (fall in rate of interest induces people to consume more and save less of the money), Investment (fall in rate of interest reduces cost of borrowing for new investments)

It will decrease: Interest rate, Income

To maintain Income, Fed must raise the money supply such that LM curve shifts to its right and economy reaches at its initial level of income.