In addition to depending on disposable income, suppose household consumption wer

Question

In addition to depending on disposable income, suppose household consumption were also
a function of the interest rate. In particular, assume that households consume more (i.e.,
save less) when the interest rate falls. Assume prices are fixed in the short run.
A) Explain how this situation would influence the shape of the IS and/or LM curves relative
to the case in which consumption is not a function of the interest rate.
B) Now use IS and LM curves to illustrate how this situation would influence the short-run
effectiveness of monetary policy.
C) What, if anything, would this modification do to the shape of the aggregate demand
curve?

Explanation / Answer

A)The IS curve will become flatter with lower intercept. This is because as interest rate(r) decreases, interest sensitivity of investment(Ip) (i,e change in v(v represents magnitude of change in Ip due to one unit change in r, which measures the interest sensitivity of Ip with respect to r)) increases more (since v is larger). So, at a constant output(Y), aggregate demand(AD) increases exogeneously by more than as before and therefore under effective demand principle product market equilibrium Y increases more than as before. The LM curve in the upward sloping region only becomes flatter. This is because with the fall in r, speculative demand for money increases more than before. The slope of the LM curve decreases henceforth resulting in a flatter LM curve. B)Here we get three cases: Case 1: when LM curve is upward sloping: LM curve shifts rightwards and IS curve doesnot shift. Here ultimately r decreases but less than the initial effect(to maintain money market equilibrium) as a part of fall in r is offset from output market. Case 2: when LM curve is vertical: Effectiveness of monetary policy to increase equilibrium Y is highest. LM curve shifts to the right, IS curve doesnot change. Case 3: when LM curve is horizontal: Both IS and LM curve doesnot shift. They remain unchanged. Effectiveness of monetary policy to increase equlibrium Y or to change in composition of output for given Y is ineffective. C) AD curve is downward sloping in ISLM model when speculative demand for money is either equal to 0 or less than 0. AD curve is vertical when the speculative demand for money is equal to infinity.

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