Question

"The effects of a consumer euphoria in the IS-MP model. Set the stage by drawing 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. Suppose that the S&P500 increases by 10 percent relative to the previous year, increasing the wealth of American consumers. Suppose that, as a result, the economy experiences a positive shock to Consumption (i.e. aC increases). Assuming the Fed keeps interest rates unchanged, compare the initial and final equilibrium points (A and B) and pick which of the following statements is correct:"

"At point B, the sum of investment and consumption will be the same as at point A because the increase in one will be offset by the reduction in the other."

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

"At point B, investment will be lower than at point A because the real interest rate has increased but the intercept term ""aI"" has not changed either. However, Consumption at point B will be higher than at point A because of the increase in aC."

"At point B, investment will be higher than at point A because the real interest rate has increased but the intercept term ""aI"" has not changed either. However, Consumption at point B will be higher than at point A because of the increase in aC."

"At point B, investment will be higher than at point A because the real interest rate has fallen but the intercept term ""aI"" has not changed either. However, Consumption at point B will be higher than at point A because of the increase in aC."

"At point B, investment will be the same as at point A because the real interest rate has not changed and the intercept term ""aI"" has not changed either. However, Consumption at point B will be lower than at point A because of the change in aC."

Answer 1

The correct statement is: "At point B, investment will be the same as at point A because the real interest rate has not changed and the intercept term ""aI"" has not changed either. However, Consumption at point B will be higher than at point A because of the increase in aC."

When the S&P500 increases by 10 percent, consumers become wealthier and this leads to an increase in consumption (aC increases). This results in a shift in the IS curve to the right, leading to a new equilibrium point B. Since the Fed has kept interest rates unchanged, the real interest rate remains the same at both points A and B. Therefore, investment will be the same at both points. However, consumption will be higher at point B due to the shift in the IS curve.