By now you should be aware that a monetary contraction leads both to a reduction in output and to an increase in the interest rate – but not both at the same time. To analyze the dynamics of the IS/LM model, you need to remember the following assumptions.

Move the LM curve upward, graphically representing a monetary contraction.

  1. What is the immediate response of the interest rate to the monetary contraction ?
  2. At the combination of output equal to Y0 and the interest rate equal to i1, is Y0 greater than or less than whatever level of output would imply equilibrium in the goods market ?
  3. What does the increase in the interest rate imply will happen to output ?
  4. As the level of output falls below Y0, what happens to the interest rate ?
  5. What is the dynamic effect of a monetary contraction on output ?
  6. What is the dynamic effect of a monetary contraction on the interest rate ?