Question

1. According to the IS-LM model, what happens in the short run to the interest rate, income, consumption, and investment under the following circumstances? Be sure your answer includes an appropriate graph.

1. The government increases taxes.

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2. The price level decreases.

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3. The central bank increases the money supply.

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4. The government decreases government purchases.

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Answer 1

a)

Increase in government tax would cause a leftward shift in the IS curve thereby establishing equilibrium at a lower level. Thus, the interest rate and output level will fall. When the level of output falls, the consumption level would also go down.

Lower demand does not motivate investment but there might small correction due to lower interest rate.

b)

Increase in the price level shifts the LM curve to left thereby driving up the interest rate in the market. Output and consumption level will fall. Higher price reduces the purchasing power of people. Higher interest rate discourages investments.

c)

When the central bank increases the money supply. it shifts LM curve to right thereby pulling down the interest rate. it raises the level of output and consumption. Lower interest rate also encourages investments.

d)

Reduction in government purchases shifts the IS curve to left, so output and consumption will be down. The interest rate will also be down. Eventually, lower interest might increase private interest-sensitive investments.