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ans9154a

# ans9154a - Econ 154b Spring 2005 Suggested Solutions to...

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Econ 154b Spring 2005 Suggested Solutions to Problem Set 9: Questions 1-3 Question 1 (a) If the Fed targets the real interest rate, then money demand shocks are offset by changes in the money supply, so the LM curve does not move. To see this, look at the figure below, which depicts the result in a Keynesian model. Initially, real money supply is given by the MS 1 line, while money demand is given by the curve MD 1 Y 1   , where Y 1 is the current level of output. Suppose a money demand shock increases money demand for a given level of output; then the money demand curve shifts to MD 2 Y 1   . This tends to increase the real interest rate. When the Fed sees the rise in the real interest rate, it increases the money supply in response to reduce the real interest rate back to its targeted level of 3%. It is successful in doing so if it increases the real money supply to MS 2 . In terms of the LM curve, the result of targeting the real interest rate is shown in the figure below. Beginning at LM 1 , the shock to money demand shifts the LM curve up and to the left to LM 2 . If the Fed does not respond, this raises the real interest rate and reduces output. But when the Fed responds by increasing the money supply by just the right amount, the LM curve shifts back to LM 1 . Since the shock causes the money supply to change, but does not affect output, the money supply is acyclical. By following the interest-rate-targeting rule, the AD curve is unaffected by money-demand shocks (since they are offset by money-supply changes), so it is more stable than if the Fed did not respond at all.

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Finally, since the AD curve does not move, the results do not change for the misperceptions version of the classical model. (b) When there are IS shocks, the rule does not work very well. Suppose a shock shifts the IS curve from IS 1 to IS 2 , as shown in the figure below. Targeting the real interest rate requires the Fed to increase the money supply to shift the LM curve from LM 1 to LM 2 . While this maintains the real interest rate at its initial level, output is above full-employment output. The money supply is procyclical, since the shift in the IS curve caused output to rise, and the increase in the money supply caused output to rise further. This response to IS
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ans9154a - Econ 154b Spring 2005 Suggested Solutions to...

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