1. The position of the FE line is determined by the
labor market and the production function. Labor supply and
demand determine equilibrium employment. Using equilibrium
employment in the production function gives the full-employment
level of output. The FE line is vertical at that point.
The FE line shifts to the right if there is an increase
in labor supply or the capital stock or if there is a beneficial
supply shock.
2. The IS curve shows combinations of the real
interest rate (r) and output (Y) that leave the
goods market in equilibrium. Equilibrium in the goods market
occurs when the aggregate supply of goods (Y) equals the
aggregate demand for goods (Cd
Id
G). Since desired national saving (Sd)
is Y – Cd – G, an equivalent
condition is Sd
Id. Equilibrium is achieved by the adjustment
of the real interest rate to make the desired level of saving
equal to the desired level of investment. For different levels
of output, there are different desired saving curves, with
different equilibrium interest rates. When plotted on a figure
showing output and the real interest rate, this forms the IS
curve, as shown in Figure 9.15. The curve slopes downward
because as output rises, the saving curve shifts along the
investment curve and the real interest rate declines.
Figure 9.15
The IS curve could shift down and to the left if: (1)
expected future output falls, because this increases desired
saving; (2) government purchases fall, because this increases
desired saving; (3) the expected future marginal product of
capital falls, because this decreases desired investment; or (4)
corporate taxes increase, because this decreases desired
investment.
3. The LM curve shows the combinations of output and
the real interest rate that maintain equilibrium in the asset
market. Equilibrium in the asset market occurs when real money
demand equals the real money supply.
Figure 9.16 shows the derivation of the LM curve and
why it slopes upward. An increase in output from Y1
to Y2 raises money demand, shifting the money
demand curve from MD(Y1) to MD(Y2).
With money supply fixed at MS, there must be a higher
real interest rate to get equilibrium in the asset market. This
gives two points of the LM curve, plotted on the right
half of the figure. The result is that higher output increases
the real interest rate along the LM curve, so the LM
curve slopes upward.
Figure 9.16
The LM curve would shift down and to the right if the nominal money
supply or expected inflation increased or if the price level or nominal interest
rate on money decreased. In addition, the curve would shift down and to the
right if there were a decrease in wealth, a decrease in the risk of alternative
assets relative to the risk of holding money, an increase in the liquidity of
alternative assets, or an increase in the efficiency of payment technologies.
5. General equilibrium is a situation in which all markets in
an economy are simultaneously in equilibrium. This is shown in
Figure 9.17 as the point at which the FE line and the
IS and LM curves intersect. If the economy is not
initially in general equilibrium, output and the real interest
rate are determined by the intersection of the IS and
LM curves. Then adjustment of the price level moves the
LM curve until it intersects the FE line and IS
curve.
Figure 9.17
6. There is monetary neutrality if a change in the nominal
money supply changes the price level but has no effect on real
variables. Once prices adjust, money is neutral in the IS–LM
model, because a change in the money supply that shifts the
LM curve is matched by a proportional change in the price
level that returns the real money supply back to its original
level and moves the LM curve back to its original
location. Classical economists believe that money is neutral in
the short run, but Keynesians believe that there may be sluggish
adjustment of the price level, so that changes in the money
supply affect output and the real interest rate in the short
run. Both classicals and Keynesians believe money is neutral in
the long run.
1. (a) The increase in desired investment shifts the IS curve
up and to the right, as shown in Figure 9.21. The price level rises, shifting
the LM curve up and to the left to restore equilibrium. Since the real interest
rate rises, consumption declines. In summary, there is no change in the real
wage, employment, or output; there is a rise in the real interest rate, the
price level, and investment; and there is a decline in consumption.
Figure 9.21
(b) The rise in expected inflation shifts the LM curve down and to the right, as
shown in Figure 9.22. The price level rises, shifting the LM curve up and to the
left to restore equilibrium. Since the real interest rate is unchanged,
consumption and investment are unchanged. In summary, there is no change in the
real wage, employment, output, the real interest rate, consumption, or
investment; and there is a rise in the price level.
Figure 9.22
(c) The increase in labor supply is shown as a shift in the labor supply curve
in Figure 9.23 (a).
This leads to a decline in the real wage rate and an increase in employment. The
rise in employment causes an increase in output, shifting the FE line to the
right in Figure 9.23 (b).
To restore equilibrium, the price level must decline, shifting the LM curve down
and to the right. Since output increases and the real interest rate declines,
consumption and investment increase.
In summary, the real wage, the real interest rate, and the price level decline;
and employment, output, consumption, and investment rise.
Figure 9.23
(d) The reduction in the demand for money gives results identical to those in
part (b).
2. The increase in the price of oil reduces the marginal product of labor,
causing the labor demand curve to shift to the left from ND1 to ND2 in Figure
9.24. At equilibrium, there is a reduced real wage and lower employment. The
productivity shock results in a shift to the left of the full-employment line
from FE1 to FE2 in Figure 9.25, as both employment and productivity decline.
Because the shock is permanent, it reduces future output and reduces the future
marginal product of capital, both of which result in a downward shift of the IS
curve. The new equilibrium is located at the intersection of the new IS curve
and the new FE line. Depending on the level of IS, the price level may increase,
decrease, or remain unchanged. If, as shown in the figure, this
intersection lies above and to the left of the original LM curve, the price
level will increase and shift the LM curve upward (from LM1 to LM2) to pass
through the new equilibrium point. The result is an increase in the price level,
but an ambiguous effect on the real interest rate. Since output is lower,
consumption is lower. Since the effect on the real interest rate is ambiguous,
the effect on saving and investment are ambiguous as well, though the fall in
the future marginal product of capital would tend to reduce investment.
Figure 9.24
Figure 9.25
The result is different from that of a temporary supply shock; when the shock is
temporary there is no impact on future output or the marginal product of
capital, so the IS curve does not shift. In that case the price level increases
to shift the LM curve up and to the left from LM1 to LM2 in Figure 9.26 to
restore equilibrium. In that case, the real interest rate unambiguously
increases. Under a permanent shock, the IS curve shifts down and to the left, so
the rise in the real interest rate is less than in the case of a temporary
shock, and the real interest rate can even decline.
Figure 9.26
3. (a) The decrease in expected inflation increases real money demand, shifting
the LM curve up, as shown in Figure 9.27. The real interest rate rises and
output declines.
Figure 9.27
(b) The increase in desired consumption shifts the IS curve up and to the right,
as shown in
Figure 9.28. This causes the real interest rate and output to rise.
Figure 9.28
(c) The increase in government purchases shifts the IS curve up and to the
right, with the same result as in part (b). (The FE line also shifts, as the
increase in government expenditures reduces people’s wealth and leads them to
increase labor supply, but this shift will not affect the short-run equilibrium,
as the economy will be off the FE line.)
(d) If Ricardian equivalence holds, the increase in taxes has no effect on
either the IS or LM curves, so there is no change in either the real interest
rate or output. If Ricardian equivalence doesn’t hold, so that the increase in
taxes reduces consumption spending, the IS curve shifts down and to the left, as
shown in Figure 9.29. Both the real interest rate and output decline.
Figure 9.29
(e) An increase in the expected future marginal productivity of capital shifts
the IS curve up and to the right, with the same result as in part (b).