Question

Based on our understanding of the IS-LM model that takes into account dynamics, we know that a reduction in the money supply will cause:

A- an immediate drop in Y and immediate increase i.
B- an immediate increase in i and no initial change in Y.
C- a gradual increase in i and gradual reduction in Y.
D- none of the the above.

Answer 1

In the dynamics of the IS-LM model, a reduction in the money supply leads to an immediate increase in interest rates (i) with no initial change in output (Y).

Step-by-step explanation:

The question relates to the IS-LM (Investment Savings - Liquidity Preference Money Supply) model within economics. In this model, a reduction in the money supply would lead to an increase in interest rates (i) as there is now less money available for lending. This immediate adjustment in interest rates is to balance the demand and supply of money. However, the effect on output (Y) is not immediate according to the dynamics of the IS-LM model. It may take time for the decreased money supply and increased interest rates to affect investment and consequently aggregate demand, which would then lead to a change in output (Y).

Considering these dynamics, the correct answer to the student's question is: B- an immediate increase in i and no initial change in Y. This reflects the model's prediction that the adjustment in the interest rate would occur before the change in output.