Draw fully labelled graphs to get full credits. (a) Use the financial market diagram to derive...

Draw fully labelled graphs to get full credits.

(a) Use the financial market diagram to derive the LM curve when there is an interest rate target. Explain.

(b) What is the slope and intercept of the LM curve when there is an interest rate target?

(c) When is a fiscal policy more effective at changing the level of output: when the central bank maintains a fixed real money supply or when the central bank sets an interest rate target? Draw the IS-LM model and explain.

Solutions

Expert Solution

LM curve explains various combination of income interest rate when demand for money is equal to money supply ( money market equilibrium ). Demand for money ( Md) is a function of income and interest rate and supply of money(Ms) is fixed. M1= Transactionary motive and precautionary motive , that is a function of income,M2= speculative motive ,So total demand for money = M1+M2. Let us draw four panel diagram to derive LM curve. First diagram shows negative relation between speculative demand for money and rate of interest. At r1, rate of interest M21 speculative demand for money and at r2 , there is M21. Second diagram shows relationship between M1 ad M2 . Third diagram shows positive relationship between M1 demand for money and income level. In fourth diagram we can derive LM curve by joining the two points A and B that shows the relationship between rate of interest and income level b. Slope of LM ,when the central bank has a interest rate target , Y =1/K ( M+hi) , Slope of LM is determined by K and h , K = income sensitivity of demand for money and h is interest sensitivity of demand for money. Larger the income sensitivity of Md or smaller the interest sensitivity of Md , steeper the LM curve will be. c. Fiscal policy is more effective when central bank has a fixed money supply and interest rate target when LM curve is horizontal and IS curve is elastic. So even the government increases its spending, there will be no crowding out effect due to fixed interest rate and money supply and fiscal policy has maximum effect on national income

Rahul Sunny answered 1 year ago

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