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CHAPTER 11
MONETARY AND FISCAL POLICY
Solutions
to
the
Problems
in
the
Textbook
:
Conceptual Problems:
1.a. An open market operation is an exchange of bonds for money or vice versa by the Fed. In an open
market purchase, the Fed buys bonds from the public (generally via government bond dealers) in
exchange for money. This action increases the monetary base and therefore the supply of money. In
an open market sale, the Fed sells bonds in exchange for money, decreasing the monetary base and
therefore the supply of money.
1.b. When the Fed undertakes open market sales, it exchanges bonds for money. This decreases the
monetary base and the resulting decrease in money supply creates a portfolio disequilibrium. The
public adjusts by selling other assets, so asset prices decrease and yields (interest rates) increase. This
increase in interest rates has a negative effect on aggregate demand (investment spending) and output
contracts. A lower level of national income reduces money demand and therefore interest rates
decline again. But if the price level is assumed to be fixed (as in the ISLM model), then interest rates
still settle at a level higher than the original one. Overall, in an ISLM diagram, the LMcurve shifts
to the left, leading to a higher level of interest rates and a lower level of income.
2.
The IScurve is vertical, if investment spending is totally interest insensitive. This is called investment
insufficiency; in this case the monetary multiplier is zero. Since the parameter b in the investment
equation equals zero, the equation changes from
I = I
o
 bi
to
I = I
o
.
A horizontal LMcurve will also render monetary policy ineffective. This is called the liquidity
trap. In this case, money demand is totally interest elastic, and the parameter h in the money demand
equation is assumed to be infinitely large.
The fiscal policy multiplier is zero if the LMcurve is vertical. This case is called the classical
case, and money demand (and money supply) is assumed to be totally interest insensitive. Since the
parameter h in the money demand equation equals zero, the equation changes from
L = kY  hi
to
L = kY.
None of these three cases is very likely to occur. However, some economists assert that Japan in
the late 1990’s and the U.S. in the Great Depression were in, or close to, the liquidity trap.
3. A liquidity trap is a situation in which the public is willing to hold, at a given interest rate, however
much money the Fed is willing to supply. In this case, the LMcurve is horizontal and monetary
policy is totally ineffective. Fiscal policy (which will shift the IScurve) is clearly the better choice to
1
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View Full Documentstimulate the economy in such a situation, since no crowding out will occur. This means that fiscal
policy will have its maximum effect.
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 Fall '10
 JIAN

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