Question

Portray an initial equilibrium denoted by the subscript 0, in the savings and Investment space, Money Market, the IS-LM space, and the AD space, and show how an increase in the money supply would affect these. Be sure to label all shift variables and list causal/ explained variables. Assume MPS < MPI.

Goods or Savings-Investment Market IS-LM IS Money Market AD -A

Answer 1

(a) Money Market

Increase in money supply shifts money supply curve to right, decreasing interest rate and increasing quantity of money. In following graph, MD0 and MS0 are initial money demand and supply curves, intersecting at point A with initial interest rate r0 and quantity of money M0. As MS0 shifts right to MS1, it intersects MD0 at point B with lower interest rate r1 and higher quantity of money M1.

MS MS IMDO Mo M M

(b) Savings-Investment

Higher money supply, by causing a fall in interest rate, increases investment, shifting investment demand curve rightward, increasing both interest rate and quantity of savings/investment. At the same time, savings decreases, shifting saving curve leftward, decreasing interest rate and increasing quantity of savings/investment. Since MPS < MPI, leftward shift in savings curve is lower than rightward shift in investment curve. As a result, interest rate increases and savings/investment increases. In following graph, I0 and S0 are initial investment and saving curves, intersecting at point A with initial interest rate r0 and quantity of savings/investment Q0. As I0 shifts right to I1 and S0 shifts left to S1, they intersect at point B with higher interest rate r1 and higher quantity of savings/investment Q1.

90 9, 5,1

(c) IS-LM

Increase in money supply shifts LM curve rightward, leading to lower interest rate and higher output. In following graph, IS0 and LM0 are initial IS and LM curves, intersecting at point A with initial interest rate r0 and output Y0. As LM0 shifts right to LM1, it intersects IS0 at point B with lower interest rate r1 and higher output Y1.

(d) AD-AS

Increase in investment increases aggregate demand, shifting AD curve rightward, increasing both price level and real GDP (output). In following graph, AD0 and SRAS0 are initial aggregate demand and short-run aggregate supply curves intersecting at point A with initial price level P0 and real GDP Y0. As investment increases, AD0 shifts right to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1.

SRASO Yo Y, Y