Question

The IS curve shows the combinations of the real interest rate and the aggregate output that represent equilibrium in the market for goods and services. The MP curve represents Federal Reserve monetary policy. For each of the following, evaluate how the IS curve and MP curve might be affected (if at all): A decrease in financial frictions. An autonomous easing of monetary policy. An increase in the current inflation rate. Firms become more optimistic about the future of the economy. The new Federal Reserve chair begins to care more about fighting inflation.

Answer 1

(1) A decrease in financial friction will make investment environment easier for investors, so investment demand will increase. The IS curve will shift rightward, increasing interest rate and quantity of investment & saving.

(2) An easing of monetary policy will increase money supply, which will shift MP curve rightward, decreasing interest rate and increasing quantity of investment & saving.

(3) Increase in current inflation rate will decrease purchasing power, which will increase the demand for money. The MP curve will shift rightward, decreasing interest rate and increasing quantity of investment & saving.

(4) When firms become optimistic about future economy, investment demand will increase. The IS curve will shift rightward, increasing interest rate and quantity of investment & saving.

(5) To fight inflation, Fed will decrease money supply, which will shift MP curve leftward, increasing interest rate and decreasing quantity of investment & saving.