Question

Interest Rate Target: Most modern central banks announce a target for a specific interest rate. Consider each of the two scenarios below, and describe how the central bank would react to maintain a constant interest rate. Draw an IS-LM graph that shows the initial shock. Then discuss the change to the money supply that would keep interest rates constant, the open market operation (bond market transactions) that the central bank does to accomplish that change, and how it shows up in the IS-LM graph. Note you don’t need to do any of the long, 3-part story discussion: just the graph and a sentence or two about the central bank’s action.

a) Uncertain about future profitability, firms reduce their investment spending.

b) Concerns about the Y2K computer bug lead to significant withdrawals of cash from banks in December 1999.

Answer 1

In each graph, IS0 and LM0 are initial IS and LM curves intersecting at point A with initial interest rate r0 and output Y0.

(a) Reduction in investment spending will shift IS0 leftward to IS1, which will intersect LM0 at point B with decreased interest rate r1 and decreased output Y1. To maintain interest rate at r0, central bank has to decrease money supply which will shift LM0 leftward to LM1, which intersects IS1 at same interest rate r0 but at a lower output Y2.

Central bank decreases money supply using contractionary monetary policy by open market sale of government securities.

(b) Withdrawal of cash from bank will increase the demand for money, which will shift LM0 leftward to LM1, which will intersect IS0 at point B with decreased interest rate r1 and decreased output Y1. To maintain interest rate at r0, central bank has to increase money supply which will shift LM1 rightward back to LM0, which intersects IS1 initial point A.

Central bank increases money supply using expansionary monetary policy by open market purchase of government securities.