Answer to Question #266599 in Macroeconomics for shon

Question

Suppose that the price level is fixed in the short run so that the economy doesn’t reach general equilibrium immediately after a change in the economy. For each of the following changes, what are the short-run effects on the real interest rate and output? Assume that, when the economy is in disequilibrium, only the labor market is out of equilibrium; assume also that for a short period firms are willing to produce enough output to meet the aggregate demand for output. a. A decrease in the expected rate of inflation. b. An increase in consumer optimism increases desired consumption at each level of income and the real interest rate. c. A temporary increase in government purchases. d. An increase in lump-sum taxes, with no change in government purchases (consider both the case in which Ricardian equivalence holds and the case in which it doesn’t). e. A scientific breakthrough that increases the expected future MPK.

Answer 1

IS represents the short run equilibrium in goods market

LM represents the short run equilibrium in money market

Short run equilibrium Y and r is determined by the intersection of IS and LM

a)Decrease in expected rate of inflation shifts LM curve left to LM' because it causes decrease in money demand. This increases real interest rate while decreasing output.

The following figure is shown below;

b) A supposed increase in consumer optimism increases desired consumption and real interest rate thus increasing IS by shifting to the right from IS to IS'. This increases real interest rate and output.

The following figure is shown below;

c) A supposed increase in government purchase also increases IS by shifting to the right from IS to IS'. This increases real interest rate and output.

The following figure is shown below;

d)Increase in taxes has no effect if Ricardian equivalence holds. However, if it does not hold, increase in taxes reduces consumption spending causing a downward shift on the IS curve. Both the real interest rate and the output decline thus, decreasing IS by shifting leftwards from IS to IS'.

The following figure is shown below;

e) A scientific breakthrough causes increase in the future expected MPK. This increases IS by shifting rightwards from IS to IS' thus, increasing real interest rate and output.

The following figure is shown below;'