Question

1. As I threatened in class, this question is about Jerome Powell’s appearance before Congress on Tuesday. He has indicated that he will continue to raise rates in the same gradual pattern set by Janet Yellen. He has indicated that he will likely raise rates three times this year.   Suppose he decides to raise interest rates at the end of March.
   1. What is happening in the market for money when the Fed pursues the monetary policy above? Use the simple model of the supply and demand for money to show what is happening. Remember:
      1. Clearly state the policy change.
      2. Clearly draw and label a graph that shows the change.
      3. Clearly state what happens to the equilibrium interest rate and the quantity of money.

2. What happens in the market for money after the Fed changes interest rates?
   1. Clearly state what is happening in the economy after the Fed pursues the policy in question 1a and why that affects the market for money.
   2. Clearly draw and label a graph that shows the change.
   3. Clearly state what happens to the equilibrium interest rate and the quantity of money.

3. How does this change (in question 1b) play out over time? Does it happen immediately or over time? What does this mean for the policy change the Fed is trying to pursue in question 1a? Does the policy have an effect in the short run? How about in the long run?

4. Now turn to bond markets and explain how the CBF’s policy change will affect the equilibrium price and quantity of bonds.
   1. Clearly state WHY the Fed’s policy will have an effect on bond markets.
   2. Clearly draw and label graphs that shows this change.
   3. Clearly state what happens to the equilibrium price and interest rate in bond markets.

5. How does this change (in question 1d) play out over time? Does it happen immediately or over time? What does this mean for the policy change the Fed is trying to pursue in question 1d? Does the policy have an effect in the short run? How about in the long run?

Answer 1

Allow us to first give an explanation for how IS-LM model suggests the result of expansionary fiscal coverage of broaden in government expenditure on degree of country wide income.

That is illustrated in Fig. 20.6. Develop in government expenditure which is of autonomous nature raises mixture demand for items and offerings and thereby explanations an outward shift in IS curve, as is shown in Fig. 20.6 the place broaden in government expenditure results in the shift in IS curve from IS1 to IS2.

observe that the horizontal distance between the 2 IS curves is equal to the develop in govt expenditure occasions the government expenditure multiplier, that is, G x 1/1-MPC which suggests the increase in countrywide sales equal to the horizontal distance EK that happens in Keynes multiplier mannequin. Nevertheless, in IS-LM mannequin exact expand in country wide earnings shouldn't be equal to EK prompted by the working of Keynesian multiplier.

That is considering with the rightward shift in IS curve rate of interest also rises which reasons discount in confidential funding. It's going to be obvious from Fig. 20.6 that, with the LM curve ultimate unchanged, the brand new IS2 curve intersects LM curve at point B. For this reason, in IS-LM mannequin with the expand in executive expenditure (G), the equilibrium moves from factor E to B and with this the cost of interest rises from r1 to r2 and revenue stage from Y1 to Y2.

Sales equal to CK has been wiped out on account that of rise in curiosity causing a decline in private investment. For that reason CK represents crowding-out outcomes of broaden in government expenditure therefore, IS-LM mannequin indicates that expansionary fiscal coverage of expand in executive expenditure raises both the extent of income and cost of interest.

It is worth noting that within the IS-LM model increase in country wide revenue via Y1 Y2 in Fig. 20.6 is less than EK which would arise in Keynes model. This is because Keynes in his simple multiplier mannequin assumes that funding is fixed and self sufficient, whereas IS-LM model takes under consideration the autumn in exclusive funding as a result of the rise in interest fee that takes location with the expand in executive expenditure. That is, increase in govt expenditure crowds out some exclusive funding.

Likewise, it can be illustrated that the discount in executive expenditure will intent a leftward shift within the IS curve, and given the LM curve unchanged, will lead to the fall in each price of curiosity and degree of sales. It should be famous that govt more often than not cuts expenditure to manipulate inflation within the economic climate.

Expansionary Fiscal policy: reduction in Taxes:

An alternative measure of expansionary fiscal policy that may be adopted is the discount in taxes which via broaden in disposable sales of the persons raises consumption demand of the individuals. As a result, reduce in taxes reasons a shift in the IS curve to the proper as is proven in Fig. 20.7 from IS1 to IS2.

It may nevertheless be famous that within the Keynesian multiplier model, the horizontal shift in the IS curve is determined by the value of tax multiplier instances the reduction in taxes (ÎT), that's, ÎT x MPC/1-MPC and factors level of income to expand through EH.

Nonetheless, in the IS-LM model, with the shift of the IS curve from IS1 to IS2 following the reduction in taxes, the economic system strikes from equilibrium point E to D and, as is obvious from Fig. 20.7, price of interest rises from r1 to r2 and stage of income raises from Y1 to Y2. Sales equal to LH has been wiped out due to the fact of crowding-out outcome on exclusive investment accordingly of rise in interest price.

However, if the federal government intervenes in the economy to slash inflationary pressures, it's going to lift the premiums of individual taxes to lessen disposable revenue of the humans. Rise in personal taxes will result in the diminish in combination demand. Lessen in combination demand will aid in controlling inflation. This case will also be shown via IS-LM curve mannequin.

Function of economic policy to make certain financial stability: defined via IS-IM Curve model:

through making suitable changes in economic policy the government can affect the extent of monetary activity. Financial policy can also be expansionary or contractionary relying on the present monetary problem.

IS-LM model can be used to exhibit the effect of expansionary and tight fiscal insurance policies. A transformation in cash supply motives a shift in the LM curve; expansion in cash supply shifts it to the correct and slash in money give shifts it to the left.

Consider the economic system is in grip of recession, the federal government (through its vital financial institution) adopts the expansionary economic policy to raise the economic system out of recession. Accordingly, it takes measures to increase the money give within the economy. The develop in cash supply, state of liquidity alternative or demand for money last unchanged, will lead to the autumn in price of interest.

At a decrease curiosity there will be more funding by using businessmen. Extra investment will cause aggregate demand and revenue to upward thrust. This suggests that with enlargement in money provide LM curve will shift to the right as is shown in Fig. 20.8.

Hence, the economic climate will transfer from equilibrium point E to D and with this the price of curiosity will fall from r1 to r2 and national sales will expand from Y1 to Y2. For this reason, IS-LM mannequin shows that growth in money provide lowers interest cost and raises income.

Now we have also indicated what's known as monetary transmission mechanism, that is, how IS-LM curve model suggests the growth in cash deliver leads to the develop in combination demand for items and offerings. We've got consequently noticeable that expand in cash give lowers the fee of interest which then stimulates more funding demand. Develop in funding demand through multiplier procedure leads to a greater increase in mixture demand and country wide earnings.

If the economic system suffers from inflation, the government will prefer to check it. Then its crucial financial institution will have to undertake tight or contractionary economic policy. To manipulate inflation the critical bank of a country can lower cash provide through open market operations via promoting bonds or executive securities in the open market and in return gets currency money from folks that buy the bonds. On this means liquidity in the banking system will also be decreased.

To minimize cash supply for fighting inflation the crucial financial institution might also lift cash reserve ratio of the banks. The greater cash reserve ratio implies that the banks have got to maintain more cash reserve with the critical financial institution. For that reason, the money reserves with the banks fall which drive them to contract credit score. With this money deliver within the financial system declines.

Thus, IS-LM model can be utilized to exhibit that discount in money deliver will cause a leftward shift in LM curve and will result in the rise in interest expense and fall in the degree of earnings. The rise in curiosity fee if you want to cause reduction in investment demand and consumption demand and help in controlling inflation. That is shown in Fig. 20.9