Prices continue to rise until the economy returns to

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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 IS2 Y2 Y 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 point A. 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 IS2 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 money. 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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This note was uploaded on 10/01/2013 for the course ECON 302 taught by Professor Alvero during the Winter '09 term at The University of British Columbia.

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