Intermediate macro econ I Consider an economy described by the figure below (Fig

Question

Intermediate macro econ

I Consider an economy described by the figure below (Figure 6-6 from the Blanchard (2017] text). IS IS LM LM' Output, Y (a) What are the units on the vertical axis of the figure? (b) If the nominal policy interest rate is 5% and the expected rate of inflation is 3%, what is the value for the vertical intercept of the LM curve? Suppose that the nominal policy interest rate is 5%. If expected inflation decreases from 3% to 2%, in order to keep the LM curve from shifting, what must the central bank do to the nominal policy rate of interest? (c) (d) If the expected rate of inflation were to decrease from 3% to 2%, does the IS curve shift? If the expected rate of inflation were to decrease from 3% to 2%, does the LM curve shift? (e) If the risk premium on risky bonds increases from 5% to 6%, does the LM curve shift? If the risk premium on risky bonds increases from 5% to 6%, does the IS curve shift? bonds from decreasing the level of output? (g) (h) What are the fiscal policy options that prevent an increase in the risk premium on risky

Explanation / Answer

a) Real interest rate is on the vertical axis and it measured as the percentage of output. Output is measured in terms of currency(dollar). Hence, units of interest rate is currency(dollar).

b) nominal interest rate = real interest rate + expected inflation rate

or

i = r + e

if, i = 5% and e = 3%

then,

r = i - e

r = 5 - 3

r = 2% or intercept is at 2.

c) If expected rate of inflation decreases to 2% then in order to keep LM curve from shifting, central bank can reduce the money supply to increase the nominal interest rate.

d) If expected rate of decreases from 3% to 2% then real rate of interest would increase to 3%. Increase in real interest rate reduces the investment. Hence, IS cuve shifts backward.

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