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 6 months ago

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