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.
- The goods market reaches equilibrium slowly; therefore,
when output is above or below the level implied by the IS
curve, it adjusts slowly to that level
- The money market reaches equilibrium immediately because
interest rates adjust quickly; this means interest rates
and output are always some combination on the LM curve
Move the LM curve upward, graphically representing a monetary
contraction.
- What is the immediate response of the interest rate to
the monetary contraction ?
- 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 ?
- What does the increase in the interest rate imply will
happen to output ?
- As the level of output falls below Y0, what
happens to the interest rate ?
- What is the dynamic effect of a monetary contraction on
output ?
- What is the dynamic effect of a monetary contraction on
the interest rate ?