Question

Using the AS-AD framework, explain how the economy adjusts to the change in money supply in the long run. Return to the IS-LM framework and explain how the real interest rate and investment respond to the change in the long run. Compare the long-run eqm. before and after the change in money demand. How do long-run values of investment, consumption and national income compare before and after the policy change? Explain.

Answer 1

Change in money supply in long run:

If money supply changes, it cause LM curve to shift leftward in short run while IS curve remains the same. It will rase the rate of interest from i to i2 while output level to fall from Y to Y1 and move economy from point A to B.

In short run when interest rate rises, people will respond by reducing their level of investment and raising their level of savings. As consumption and saving equals income, rise in saving (due to rise in rate of interest) would reduce consumption level.

Caps Lock 5 € 6 Interest Rote IS yr y Output

In long run when due to reduction in money supply, people have less money in their pockets to spend over goods, it will reduce their willingness to pay for the goods and reduce aggregate demand. It will shift the IS curve to its left in long run from IS to IS1. It will reduce the rate of interest to its initial position of i and reduce level of output further to Y2.

In long run, when interest rate falls to initial level, investment will also raise to its initial level while savings will fall.

In long run, economy shifts from point A to C.

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