Question

Your day as the chair of the FED: Suppose you are appointed as the chair of the US Federal Reserve. “With the sole goal of stabilizing output”, explain how and why you would change the interest rate in response to the following shocks. Show the effects on the economy in the short run using the IS-MP diagram. Be sure to discuss what changes in the model specifically. Provide detailed intuitive explanation in words as well. (You can assume that the economy, before the shock, is at the benchmark point.)

A. Firms become pessimistic about the state of the economy and hence decrease the investment. (Note that this happens initially without any change in the interest rate).

B. Suppose some of Latin American economies succumb to a recession and significantly reduce their demand for the U.S. good

Answer 1

Ans A. As the pessimistic outlook leads to decrease in investment leading to leftward shift of IS curve from IS to IS’ causing output to fall from Y to Y’ and interest to fall from i to i’. If FED wants to keep output constant, so, it has to use a monetary expansion which will lead to fall in intetest rate and rightward shift in MP from MP to MP’ curve increasing output from Y’ to Y this is because decrease in interest rate will induce investment and consumption.

B. A reduction in demand for exports lead to decrease in net exports causing IS curve to shift leftward leading to decrease in output from Y to Y’ and interest rate from i to i’. To maintain the putput at level of Y, moneytary expansion should be used by FED, which will lead to decrease in interest rate shifting MP curve to right from MP to MP’. This will increase output from Y’ to Y because decrease in interest rate will induce investment and consumption.

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