Unformatted text preview: Econ 302 Intermediate Macroeconomics
TA: Iain Snoddy Week 12:
Solutions IS-LM & Aggregate Supply
Problem 1 (a) First let us consider the IS-LM model. When there is a monetary expansion,
the interest rate is lower for all levels of Y. We know this as r must fall to
clear the money market. This cause a shift out in the LM curve. We are
at the new equilibrium point B below. Money Expansion in the ISLM model
1 ECON 302 Week 12 As the price level has not changed in the short run. This brings about a
shift outwards in the aggregate demand curve. For a given price level, the
level of output that clears the money and goods markets is now higher.
However, we must also consider aggregate supply. In the diagram below the
Long run level is xed at Y . However, in the short run supply can adjust.
We know that adjustments in aggregate supply result from adjustments to
the equation Y = Y + α(P − EP ).
Due to an increase in Aggregate Demand, output is above it's natural level,
ie Y > Y . As a result prices rise. The new short run equilibrium is at
point Ynew on the gure below. This price increase has ramications for
the IS-LM model. The LM curve will begin to shift left again prompting a
movement along the AD2 curve. An Aggregate Demand Shift
Let us analyse the long run. In the long run prices will increase which
moves LM curve back to its original level. However, as this result is price
driven it causes only a movement along the AD2 curve until the long run
level of equilibrium Y is reached. But what causes this return to the long
run level? The answer is a shift left in the SRAS curve as shown below. 2 ECON 302 Week 12 A SRAS contraction
We can trace this eect using the curve,
Y = Y + α(P − EP ) As prices rise in the economy, individuals expectations change. We know
that this causes a shift left in the SRAS curve. As these expectations shift
and become more aligned with prices, output falls back to its long run level.
In summary, the monetary expansion induced a shift in aggregate demand
and a short run increase in output and prices. Due to changing expectations
the supply curve shifts left which counterbalances this eect in the long run.
We could also look at the Phillips curve, π = Eπ − β(u − un ) + v . In the
short run prices rise as unemployment falls below its natural rate, however
in the long run expected ination increases until it equals the real ination
rate. As such unemployment must fall back to its natural rate.
(b) When all price changes are expected, nothing happens. The economy never
moves from the long-run. The LM curve does not move at all. An increase
in prices immediately cancels out the rise in money supply. The AD curve
still shifts to the right as a result of increased money supply. The SRAS
curve however shifts left immediately and so the economy never moves from
3 ECON 302 Week 12 the long run level of output although prices have risen.
Problem 2 Given the detailed answer to Problem 1, and the similarity of the next two
questions I will not go through them in excessive detail
(a) In this case the IS curve shifts out as shown below.This prompts a shift out
in the AD curve from AD1 to AD2. In the short run prices increase a little
and so there is movement along the AD2 curve until the new equilibrium
point at Ynew also shown below. (a) Shift in IS (b) A shift in AD In the long run however, expectations catch up with price changes. This
prompts a shift left in the SRAS curve as shown below. The result of this
is a price change that cancel out the eect of an increase in Government
purchases. In the long run prices are now permanently higher but output
is at its long run level. 4 ECON 302 Week 12 A SRAS contraction
But what happens the IS-LM diagram in this case? The rise in prices shifts
the LM curve to the left. Thus the IS-LM equilibrium is at the natural rate
of output, but there has been an increase in the real rate of interest. This
is because prices have caused a fall in money demand. The IS-LM diagram
is shown below. A LM shift
The Phillips curve relationship is similar to that of problem 1. Initially
prices rise as output rises above its long run level. Eventually expectations
change until output and natural output equate.
(b) The eect of a tax change is the mirror image of an increase in government
5 ECON 302 Week 12 expenditures. Except that we know a tax change has a smaller impact in
this framework than a change in spending.
A tax increase shifts the IS curve to the left as shown below. This brings
about a shift left in Aggregate demand as output is lower for every price
level. This is also shown below. (a) An IS shift (b) An AD shift Prices fall until the new SR equilibrium is reached at Ynew. In the long run
however, individuals expect a lower price level. This cause a shift right of
the SRAS curve. This is shown below. Prices have fallen here and output is
returned to its long run level. This implies an initial rise in unemployment
using the Phillips curve. A SRAS expansion
6 ECON 302 Week 12 The fall in prices shifts the LM curve to the right. The new long run
equilibrium reduces the real interest rate. A LM expansion 7 ...
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