Question

3. An economy is initially in long run equilibrium. Show the short run and long run changes in the IS/LM diagram and AD/AS diagram in each of the following cases. (a) Government spending decreases. (b) The central bank raises the required reserve ratio

Answer 1

(a)

Lower government spending will decrease output, shifting IS curve leftward, decreasing interest rate and decreasing output in short run. In long run, lower interest rate increases demand for money, which shifts LM curve rightward, intersecting new IS curve at further lower interest rate, but at original output level.

In following graph, IS0 & LM0 are initial IS & LM curves intersecting at point A with initial long run interest rate r0 and output Y0. When IS0 shifts left to IS1 in short run, it intersects LM0 at point B with lower interest rate r1 and lower output Y1 in short run. In long run, LM0 shifts right to LM1, intersecting IS1 at point C with further lower interest rate r2 and original output Y0.

SA LMo 1S LMI 8 0

Lower government spending will decrease aggregate demand, shifting AD curve leftward, decreasing price level and real GDP, creating a short run recessionary gap. In long run, lower price level lowers input costs, so firms raise production, increasing aggregate supply. SRAS shifts rightward, intersecting new AD curve at further lower price level but restoring original output level.

In following graph, long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect, with long-run equilibrium price level P0 and real GDP (which is equal to Potential GDP) Y0. When AD0 shifts to AD1, in short run, it intersects SRAS0 at point B with lower price level P1 and lower real GDP Y1, creating recessionary gap of (Y0 - Y1) in short run. In long run, SRAS0 shifts right to SRAS1, intersecting AD1 at point C with further lower price level P2 and restoring real GDP to potential GDP level Y0.

LRASo SRAS 0 5RAS, 0 ADo 2 ADI I Yo

(b)

Increase in required reserve ratio will decrease money supply, shifting LM curve leftward, increasing interest rate and decreasing output in short run. In long run, expectations adjust upward, which shifts IS curve rightward, intersecting new LM curve at further higher interest rate, but at original output level.

In following graph, IS0 & LM0 are initial IS & LM curves intersecting at point A with initial long run interest rate r0 and output Y0. When LM0 shifts left to LM1 in short run, it intersects IS0 at point B with higher interest rate r1 and lower output Y1 in short run. In long run, IS0 shifts right to IS1, intersecting LM1 at point C with further higher interest rate r2 and original output Y0.

LMI LMo Lo 1S LSo

Higher interest rate caused by lower money supply will reduce investment demand which will decrease aggregate demand, shifting AD curve leftward, decreasing price level and real GDP, creating a short run recessionary gap. In long run, lower price level lowers input costs, so firms raise production, increasing aggregate supply. SRAS shifts rightward, intersecting new AD curve at further lower price level but restoring original output level.

In following graph, long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect, with long-run equilibrium price level P0 and real GDP (which is equal to Potential GDP) Y0. When AD0 shifts to AD1, in short run, it intersects SRAS0 at point B with lower price level P1 and lower real GDP Y1, creating recessionary gap of (Y0 - Y1) in short run. In long run, SRAS0 shifts right to SRAS1, intersecting AD1 at point C with further lower price level P2 and restoring real GDP to potential GDP level Y0.

LRASo SRAS 0 5RAS, 0 ADo 2 ADI I Yo