Unformatted text preview: n increase taxes reduces disposable income for consumers, shifting the IS c the I the
curve in Figure 11– shown in Figure 11–24. and the interest rate decline to Y2 and r
as shown to the left, as24. In the short run, outputIn the short run, output and the inter-2 as the
est rate decline to Y2 and to point economy moves from point A to point B.
economy moves from point A r2 as theB.
r Y= Y LM1 Figure 11–24
LM2 Interest rate 112 lowers real balances, which raises the interest rate. As indicat- ed in Figure 11–22, the LM curve
shifts back to the left. Prices continue to rise until the economy returns to its original position at
point A. The interest rate returns to r1, and investment returns to its original level. Thus, in the
long run, there Questions and Problems
Answers to Textbook is no impact on real variables from an increase in the money supply. (This is what
we called monetary neutrality in Chapter 4.) r1
r2 B A
C r3 IS1
Income, output Y r Y= Y LM1 Figure 11–24
LM2 Interest rate c. level of output. Unlike monetary policy, however, it can change the composition
of output. For example, the level of investment at point C is lower than it is at
An increase in taxes reduces disposable income for consumers, shifting the IS
curve to the left, as shown in Figure 11–24. In the short run, output and the interest rate decline to Y2 and r2 as the economy moves from point A to point B. r1
r2 B A
C r3 IS1
Y2 Y Y Income, output Initially, the LM curve is not affected. In the longer run, prices begin to decline because output is
below its long-run equilibrium level, and the LM curve then shifts to the right because of the
increase in real money balances. Interest rates fall even further to r3 and, thus, further stimulate
investment and increase income. In the long run, the economy moves to point C. Output returns
to Y, the price level and the interest rate are lower, and the decrease in consumption has been
offset by an equal increase in investment.
10. Chapter 11 Problem #7
a. All shocks to the economy arise from exogenous changes in the demand for
goods and services.
Answer: Shocks in the demand for goods and services are shocks to the IS curve so the IS curve
shifts. If we suppose that the shock is a positive one then the IS curve shifts rightward. Under
policy 1 where the Fed does nothing the graph would look like that in question 1b, that is, the
interest rate increases and output increases but this has been partially offset by some crowding out
of investment. In policy 2 the Fed must keep the interest constant then with the same positive IS
curve shock the LM curve must shifts rightward by the same amount that the IS curve shifts; that
is, the money supply must expands to keep r constant. This will prevent any crowding out of
investment and so the output increase is larger in this case. Policy 2, an interest rate targeting
policy, reinforces the demand shock and expands output further. In essence under policy 2 the
Fed exacerbates the shock causing output to change by more than just the shock. Put another way,
the Fed accommodates the exogenous increase in the demand for goods and services with extra
money since households and firms will need higher money balances for transactions purposes.
b. All shocks to the economy arise from exogenous changes in the demand for
Answer: Here there is a shock to the money side; suppose the shock is a decrease in the demand
for money. This creates an excess supply of money at the original interest rate. An excess supply
of money implies an excess demand for bonds, so the price of bonds rises and interest rates fall.
This shock shifts the LM curve rightward or downward. If the Fed does nothing interest rates fall
and output expands since investment spending will respond within 9 to 18 months to the lower
borrowing costs. If the Fed takes action to keep the interest rate constant, however, it must reduce the nominal money supply, Ms, by exactly as much as money demand fell. This shifts the
LM curve back to its original position and interest rates and output would return to their original
levels. In this case, interest rate targeting, stabilizes both interest rates and output and
employment. In sum, a monetary policy that acts to mitigate any shocks to the money side
stabilizes both interest rates and output. Put another way, monetary shocks that are stabilized with
monetary policy will keep interest rates and output constant; in a sense the correct tool is being
used to solve the problem....
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