Question

Draw fully labeled graphs to get full credits. (a) Write out the IS relation and the LM relation (use the real money demand equals to real money supply).

(b) Suppose now the central bank increases money supply. What open market operations will central bank exercise in this case? Draw the financial market diagram to show the effect on interest rate for a given real output Y.

(c) Using your answer for (b), draw the IS-LM model to show the effects on interest rate and output. What happens to the components of demand (C and I)? Explain why.

(d) Now suppose in addition to the expansionary monetary policy, the government want to reduce budget deficit at the same time. Draw the effects of these two policies together in one IS-LM graph. What happens to equilibrium interest rate? Output?

Answer 1

SOLUTION:-

(a) The IS relation states that:

Y = C + I + G

Where Y is Output ,C represent consumption expenditure, I represents innverstment expenditure and G represents government expenditure.

The Lm relation states that

Money demand = Money supply

KY - hi = M/P

(b) The Central Bank will purchase government securities in the open market in order to increase money supply. This is deficted as:

In the many market above, initial equilibrium accurs at point E₁ increase in money supply will shift equilibrium to point E₂ where rate of interest has decreased in the money market.

(c) Increase in money supply will shift the LM curve rightwards to LM' and thus at new equilibrium point E₂ the rate of interest has decreased and National Output has decreased.

As rate of interest decreases, the investment in the economy will increase as rate of interest is cost of investment. It also reduces savings which inturn increases consumption in the economy .

(d) To reduce budget deficit, government reduces its expenditure and increase taxes which will shift IS to IS to IS¹ and at new equilibrium E₃, rate of interest has further decreased to 0i₃ Thus, rate of interest decreases and impact on National Output is gives as it depends on the magnitude of shifts of IS and LM curves.