Question

When thinking about the adjustment process, remember that underlying the aggregate demand curve are the IS and LM curves.

a.Assume that the economy is initially in equilibrium, but that then the IS curve is shifted out. Using two IS - LM diagrams, show the adjustment process (i) for the case when the economy returns directly to equilibrium and (ii) for the overshooting case. Briefly explain your diagrams.

b.Repeat part a for the case where the LM curve is initially shifted out. Briefly explain your diagrams.

Answer 1

a)

IS curve shifts outwards. For the adjustment when the economy directly returns to equilibrium-

(i) Autonomously, the increase in demand in goods market leads to a shift in IS curve.

(ii) Due to increase in IS, people need more money to spend. Hence, there is an increase in money demand, which increases interest rate to r’. This is overshooting of exchange rate. This increases AD and the output shifts outwards.

b)

A direct shift is when the there is and increase in money spending by people, there has to be an increase in supply of goods. This decreases the interest rate and the output increases.

Also, due to increase in money supply, the bond prices increases. It decreases the interest rate and increases the output.