Question

Suppose the Bank of Canada cares only about keeping the economy close to full-employment output. The Bank can target the real money supply (thus keeping the LM curve fixed) or it can target the real interest rate—changing the money supply and shifting the LM curve, however, is necessary to prevent a change in the real interest rate.

a.   Which is the best policy if the main shocks to the economy are shocks to the IS curve? Explain why.

b.   Which is the best policy if the main shocks to the economy are shocks to real money demand? Explain why.

Answer 1

Various ISLM diagrams are drawn by taking level of interest rate on Y axis and level of output on X axis. Diagrams in panel 1 and panel 3 represent the case when the bank treats money supply as constant while panel 2 and panel 4 represent the case when the bank makes changes to money supply to hold the interest rate constant (making LM curve horizontal).

(a) If the main shocks to the economy are shocks to the IS curve, let IS curve shift from IS₁ to IS₂ in diagrams 1 and 2. The output in both diagrams changes from Y₁ to Y₂. Since it is given that bank does not want to cause large fluctuations in output, the best policy would be to keep the money supply constant. This is so because Y₁Y₂ (or the fluctuation in output) is smaller in diagram 1.

(b) If all the shocks in the economy are shocks to real demand money, that is, it means they are shocks to the LM curve. If banks chooses to hold interest rate constant by adjusting money supply then there is no effect on LM curve (as shown in figure 4). Here, the shocks in money demand are neutralized by adjusting money supply. This consequently results in no fluctuations in output level. Thus, if all shocks are shocks to demand money, the best policy would be to adjust money supply by keeping interest rate constant.