Question

Suppose our IS/LM model from class is adjusted so that y = c (y – T, confidence) + I (I + premium, confidence) + G m/p= L (i, y) i = Federal Funds rate

Suppose the government takes action to improve the solvency of the financial system. Assume that there is an unusually high premium added to the federal funds interest rate when firms borrow at the moment. If the government action is successful, and banks become more willing to lend, what will happen to i and y in our IS/LM framework? Can we consider financial policy a kind of macroeconomic policy? Explain.

Faced with a zero nominal interest rate, suppose the Fed decides to purchase securities to facilitate the flow of credit in the financial markets. This policy is called quantitative easing. If quantitative easing is successful, so that it becomes easier for financial and non-financial firms to obtain credit, what will happen to i and y in our IS/LM framework? It is, therefore, true that the Fed has no policy options to stimulate the economy when the Federal funds rate is zero?

Answer 1

1. If banks become more willing to lend, interest rates will reduce, increasing liquidity. This increase in liquidity may or may not increase Y. This depends on quantity theory of money. i.e. M*V= P*Y (M - nominal money supply, V - velocity, P- Price levels, Y - Real output)

If M increases, then P may go up, i.e. there might be inflation in the economy and Y may not go up.

This kind of macroeconomic policy is called as expansionary monetary policy.

If Y is to be increased by increasing M, then central bank has to keep a check on P (i.e. inflation)

If every thing goes well, then increase in liquidity, will reduce interest rates, will boost investments and economy will revive and Y will go up. But, there are many limitations to this, because Y depends majorly on consumption.

2. When interest rates go down to zero, there is no scope for interest rates to go below that. This situation is known as liquidity trap. In this situation, monetary policy becomes ineffective and cannot stimulate investments in the economy. So, interest rates cant be reduced and Y cannot be stimulated.