The effects of a consumer euphoria in the IS-MP model

• Draw the diagram corresponding to an initial equilibrium where there are no AD shocks (normal-times AD) and the Fed sets the real interest rate equal to the MPK. Label the initial equilibrium as point A in the diagram.

Q1: Suppose that the S&P500 increases by 10% relative to the previous year, increasing the wealth of the average American consumer. Suppose that, as a result, the economy experiences a positive shock to Consumption (i.e. aC increases). Suppose that the Fed keeps interest rates unchanged. Which of the statements below is correct?

a. The increase in aC implies an increase in the real interest rate. As a result, the IS curve will shift to the right. Since the MP shifts up, SRO will increase from a zero value (point A) to a positive value (point B).

b. The increase in aC implies a negative AD shock. As a result, the IS curve will shift to the left. Since the MP curve stays constant, SRO will fall to a negative value (point B).

c. The increase in aC implies an inflation shock. As a result, the IS curve will shift to the left. Since the MP curve stays constant, SRO will fall from a zero value (point A) to a negative value (point B).

d. The increase in aC implies a positive AD shock. As a result, the IS curve will shift to the right. Since the MP curve stays constant, SRO will increase from a zero value (point A) to a positive value (point B).

Q2: Comparing the initial and final equilibrium points (A and B), which of the following statements is correct? It is helpful to review the equations for the IS curve and its components.

a. At point B, Investment and Consumption will be the same as at point A because the MPK has not changed.

b. At point B, Consumption will be the same as at point A because the real interest rate has not changed and aI has not changed either. However, Investment at point B will be higher than at point A because of the increase in aC.

c. At point B, Investment will increase relative to point A but Consumption will fall in exactly the same amount.

d. At point B, Investment will be the same as at point A because the real interest rate has not changed and aI has not changed either. However, Consumption at point B will be higher than at point A because of the increase in aC.

Q3: Suppose the Fed is worried about an increase inflation and wants to lower SRO back toward zero. What will the Fed do? Assume the IS curve remains at the same position as in the previous question. Draw the new equilibrium in the diagram and label it as point C. Which of the statements below is correct?

a. The Fed will take actions to increase the real interest rate. At point C the real interest rate will be higher than the MPK and SRO will be equal to zero. Graphically, point C lies horizontally to the right of point A.

b. The Fed will lower the Fed Funds Rate. At point C the real interest rate will be lower than the MPK and SRO will be equal to zero. Graphically, point C lies vertically above point A.

c. The Fed will take actions to increase the real interest rate. At point C the real interest rate will be higher than the MPK and SRO will be equal to zero. Graphically, point C lies vertically above point A.

d. The Fed will take actions to increase the real interest rate. At point C the real interest rate will be higher than the MPK and SRO will be equal to zero. Graphically, point C lies horizontally to the leftt of point A.