Consider an economy that is subject to unexpected IS and LM shocks. Suppose Central Bank has...

Consider an economy that is subject to unexpected IS and LM shocks. Suppose Central Bank has two policy options: it will either keep the interest rate or the nominal money supply constant. For each type of shock, deduce which policy is more successful in reducing the variation in output.

Expert Solution

If all shocks to the economy arise from the exogenous changes in the demand for goods and services, this means that all shocks are to the IS curve. Suppose a shock causes the IS curve to shift from IS1 to IS2. The figures below show what effect this has on output under the two policies. It is clear that output fluctuates less if the Fed follows a policy of keeping the money Y r LM IS Y r LM IS supply constant. Thus, if all shocks are to the IS cruve, then the Fed should follow a policy of keeping the money supply constant.

If all shocks in the economy arise from exogenous changes in the demand for money, this means that all shocks are to the LM curve.When the Fed maintains a strategy of changing the money supply to maintain the interest rate stable, so the LM curve does not change in reaction to such shocks – the Fed does adjust the money supply instantly to hold the money market in equilibrium. It is obvious that production fluctuates less if the Fed retains the interest rate constant and balances money demand shocks by adjusting the money supply, then all variability in output is eliminated. Thus, if all shocks are to the LM curve, then the Fed should adjust the money supply to hold the interest rate constant, thereby stabilizing output. so, thats why holding the money supply constant is succesfull policy because its reduce the variation in output.

Rahul Sunny answered 7 months ago

Suppose that the central bank in this economy is concerned that inflation is too high and...

Suppose that the central bank in this economy is concerned that inflation is too high and wants to lower the inflation rate by 6 percentage points per year. A reduction in the rate of inflation is known as d sinflation . To reduce inflation from 8% to 2% in the short run, the central bank would have to accept an unemployment rate of ____________ . True or False: If people have rational expectations, the economy may not have to endure...

Suppose an economy has been having very high inflation. The central bank has decided to decrease...

Suppose an economy has been having very high inflation. The central bank has decided to decrease the money supply in hopes of decreasing GDP (the thinking is that by decreasing GDP, it will lead to lower inflation – no need to make that connection, just focus on the goal of decreasing GDP). Using the complete Keynesian model, explain in as much detail as possible what will likely happen to the economy (including GDP, the interest rate, investment spending, any multiplier...

Consider an economy described by the IS-LM-PC model, and suppose that agents in it have unanchored...

Consider an economy described by the IS-LM-PC model, and suppose that agents in it have unanchored inflation expectations. Finally, assume that the economy begins at the medium run equilibrium with a positive medium run rate of inflation. Invariably, a drop in consumer confidence in this economy will produce the following immediate outcome. Select one: a. Inflation acceleration; b. A decrease in potential output; c. Deflation; d. Disinflation;

Suppose country A has a central bank with full credibility, and country B has a central...

Suppose country A has a central bank with full credibility, and country B has a central bank with no credibility. How does the credibility of each country’s central bank affect the speed of adjustment of the aggregate supply curve to policy announcements? How does this result affect output stability? Use an aggregate supply and demand diagram to demonstrate.

Suppose in an economy which is producing at its potential output, the central bank decides to...

Suppose in an economy which is producing at its potential output, the central bank decides to implement an expansionary monetary policy. Using the AD-AS model, explain the effect that this policy will have in the short run, and in the long run. Illustrate your answer with a diagram.

Suppose the economy is initially at a long-run equilibrium. Then the central bank increases the money...

Suppose the economy is initially at a long-run equilibrium. Then the central bank increases the money supply. Assuming any resulting inﬂation is unexpected, explain any changes in GDP, unemployment, and inﬂation in the short-run that are caused by the monetary expansion. Explain your conclusions using three diagrams: (i) one for the IS-LM model, (ii) one for the AD-AS model, and (iii) one for the Phillips curve.

In the IS-LM model there is similtaneous decrease in tax and interest rate, the central bank...

In the IS-LM model there is similtaneous decrease in tax and interest rate, the central bank controls the interet rate a) discuss the magnitudes, slopes and their impact on policy effectiveness b) Explain what effect this particular policy mix will have on output and the money supply. c) Based on your analysis, do we know with certainty what effect this policy mix will have on invedtment use diagrams

7. Consider an economy experiencing a decline in business confidence. Assume that the central bank uses...

7. Consider an economy experiencing a decline in business confidence. Assume that the central bank uses the real interest rate as its policy instrument and its ultimate objective is to keep output at the full-employment level. A. Use the IS-LM model to explain and illustrate the impact of this shock on the equilibrium output level. B. What is the appropriate Central Bank response to this shock? Illustrate and explain how the central bank uses open market operations under these circumstances....

Consider an economy in which the central bank uses the interest rate as its policy instrument....

Consider an economy in which the central bank uses the interest rate as its policy instrument. The policy-makers judge that the unemployment rate is too high and decide to pursue expansionary monetary policy to raise the output level. a. Illustrate and explain how expansionary monetary policy is expected to raise the output level. How would components of aggregate demand be affected by this policy? b. What are the limitations of expansionary monetary policy? What are the options available to the...

Suppose you run the central bank in an open economy. What happens to the following variables...

Suppose you run the central bank in an open economy. What happens to the following variables of interest in response to the below events (analyze each event separately)? I) The president cuts government spending to reduce the budget deficit II) The president restricts the import of Chinese goods Use the standard open economy IS-LM model (not the Fleming-Mundell model). Also, assume direct effects of shifts are larger than indirect effects. a) IS – Direct Effect (increase / decrease / indeterminate...

Question