Question

The IS curve shows the combinations of the real interest rate and the aggregate output that represent equilibrium in the market for goods and services. The MP curve represents Federal Reserve monetary policy. For each of the following, evaluate how the IS curve and MP curve might be affected (if at all):

• A decrease in financial frictions.
• An autonomous easing of monetary policy.
• An increase in the current inflation rate.
• Firms become more optimistic about the future of the economy.
• The new Federal Reserve chair begins to care more about fighting inflation.

Answer 1

1. Where there is less financial friction, the market economy becomes easy for investors and they will find to easy to invest. Thus, demand for investment will increase and IS curve will shift rightward. Hence, interest rate will increase, and also equilibrium output.

2. Where there is easing of monetary policy, this means that money supply in the economy. will increase and thus, MP curve will shift rightward. Interest rate will fall and output will increase.

3. When the current inflation rate rises, this will reduce the purchasing power of people and hence, demand for money will increase. This will shift MP curve rightward and, resulting in decreased interest rate.

4. When firms become optimistic about future of the economy, they will expect more demand and favourable environment for the investment. Thus, investment will increase and this will shift the IS curve to the right, and interest rate will increase.

5. When Fed begins to care more about inflation, it will control money supply in the economy and hence, MP curve will shift leftward. This will increase the interest rate and decrease the level of equilibrium output.

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