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Gordon_Answers11e_ch04 - Chapter 4 Monetary and Fiscal...

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Chapter 4 Monetary and Fiscal Policy in the IS-LM Model 33 In Section 4-6, the Box: “How Easy Money Created a Boom and Bust in Housing” has been changed from the title “How Monetary Policy Actually Worked in 2001–2004.” This box has been extended with a newer explanation of how the Fed’s policy may have created the so-called “mortgage market” sub prime mortgage market crisis in the years 2006 and 2007. He has updated the data in the figure “A Tale of Two Interest Rates.” A new subsection or B-head, “The LM Curve Can also be Shifted by Changes in the Demand for Money,” has been included. In Section 4-10. IP Box : “Monetary and Fiscal Policy Paralysis in Japan ‘Lost Decade’” has been updated with newer data and diagrams. A footnote about the reference has been replaced. A new subsection with the title “Infrastructure, Minneapolis, and the Monetary-Fiscal Policy Mix” has been included to reveal the role of government investment expenditures on national infrastructure and why they are important for long-run economic growth. Answers to Questions in Textbook 1. As a medium of exchange, money is used by people and businesses in transactions when they are spending income and paying for resources used in the production of output. Therefore, when income rises, the value of those transactions increases, resulting in a greater demand for money. Money is also used as a store of value because it can be easily exchanged for goods and services. However when the interest rate rises, people and businesses are willing to give up some of this convenience in order to earn a higher interest rate. So the demand for real cash balances declines as the interest rate rises. 2. When the economy is “off” the IS curve, planned expenditure will not equal output. If the economy is to the “left” of the IS curve, E p > Y , and there is a negative unplanned inventory change. Firms will increase output until E p = Y . As firms seek funds with which to increase inventory investment, they will bid up the interest rate. Thus, the movement will tend to be upward and to the right. If the economy is to the “right” of the IS curve, there is a positive unplanned inventory change and either output, the interest rate, or both will decline. 3. When the economy is “off” the LM curve, the demand for real money balances will not equal the supply of real balances in the economy. If the economy is to the left of the LM curve, the amount of money demanded, given the interest rate and income level, is less than the money supplied. Then, individuals will attempt to “get rid of” the excess money; this activity will cause bond prices to rise and interest rates to fall. This process will continue until interest rates fall enough to cause equality between the demand for real balances and the money supply. It is also possible that individuals will “get rid of” their excess money balances by spending them on goods and services. Then, the movement will be downward and to the right. The opposite movements will occur if the economy
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