Question

Consider a closed-economy IS–LM model. The IS and LM equations are \[ Y=C(Y)+I(z)+\bar G,\qquad \frac{\bar M}{\bar P}=kY-l\,i, \] where \(z\equiv i-\pi^{e}\). Suppose everyone suddenly expects higher future inflation \((\uparrow \pi^{e})\). Assuming the LM curve remains unchanged, what happens in the short run?

• A. Equilibrium $Y$ increases.
• B. Aggregate demand remains unchanged.
• C. Equilibrium $Y$ remains unchanged.
• D. Aggregate demand shifts down.

Hint:

Use $z=i-\pi^{e}$: a rise in expected inflation lowers the real rate at a given $i$, boosting $I$ and shifting IS right. With LM fixed, AD shifts down/right (higher $Y$ at each $P$).

Answer 1

The Correct Option is D

Step 1: Effect of higher expected inflation on the IS curve
Investment depends on the {ex-ante real interest rate} $z=i-\pi^{e}$ with $I'(z)<0$. When $\pi^{e}$ rises, $z$ falls $\Rightarrow$ investment rises $\Rightarrow$ IS shifts right for any given nominal $i$.
Step 2: LM unchanged
LM is $\bar M/\bar P = kY - l i$; with $\bar M$ and $P$ given and “LM unchanged,” the money market relation is the same for every $P$.
Step 3: Implication for the AD curve
The AD curve is the {locus of $(P,Y)$ pairs} where IS and LM simultaneously hold. Because the IS has shifted right while LM is unchanged, at {each} price level $P$ the equilibrium output $Y$ that clears the two markets is higher. In $(P,Y)$ space, a higher $Y$ at every $P$ means the AD curve shifts down/right. Hence, Aggregate demand shifts down.
Comment on option (A): If prices are sticky, the down/right shift of AD would indeed raise short-run $Y$. The question, however, asks what happens to the {AD curve}; therefore (D) captures the fundamental shift.