Question

According to the IS-LM model, what happens in the short run to the interest rate, income, consumption, and investment under the following circumstances?

a. The central bank increases the money supply.

b. The government increases government purchases.

c. The government increases taxes.

d. The government increases government purchases and taxes by equal amounts.

Answer 1

a. When the central bank increases money supply, the supply of real money balances increases owing to a fall in real interest rate, at every given income level. This implies a downward shift in the LM curve, which is a locus of real interest rate for which the market of real money balances is in equilibrium, given various levels of income.

A downward shift in the LM curve leads to a fall in the real interest rate and a rise in the equilibrium income in the IS-LM diagram. The fall in interest rate leads to a rise in investment, and the rise in income leads to increase in consumption.

b. An increase in government purchases shifts up the planned expenditure curve in the Keynesian cross model. This means, given an interest rate, the income level for which the goods and services market is in equilibrium increases. This implies a rightward shift in the IS curve.

A rightward shift in the IS curve leads to a rise in the real interest rate and a rise in the equilibrium income in the IS-LM diagram. The rise in interest rate leads to a fall in investment, and the rise in income leads to increase in consumption.

c. An increase in government taxes shifts down the planned expenditure curve in the Keynesian cross model. This means, given an interest rate, the income level for which the goods and services market is in equilibrium decreases. This implies a leftward shift in the IS curve.

A leftward shift in the IS curve leads to a fall in the real interest rate and a fall in the equilibrium income in the IS-LM diagram. The fall in interest rate leads to a rise in investment, and the fall in income leads to decrease in consumption.

d. When government increases purchases and taxes by equal amount, then the overall change in spending is positive. This is because the increase in govemment spending is compensated not only by decrease in consumption but also by decrease in spending. In the Keynesian cross diagram, planned expenditure curve shifts up. This means, given an interest rate, the income level for which the goods and services market is in equilibrium increases. This implies a rightward shift in the IS curve.

A rightward shift in the IS curve leads to a rise in the real interest rate and a rise in the equilibrium income in the IS-LM diagram. The rise in interest rate leads to a fall in investment, and the rise in income leads to increase in consumption.