The IS-LM view of the world with more complex financial markets Consider an econ

Question

The IS-LM view of the world with more complex financial markets Consider an economy described by Figure 6-6 in the text. a. What are the units on the vertical axis of Figure 6-6? 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? C. Suppose the nominal policy interest rate is 5%. If expected inflation decreases from 3% to 2%, in order to keep the LM curve from shifting in Figure 6-6, what must the central bank do to the nominal policy rate of interest? d. If the expected rate of inflation were to decrease from 3% to 2%, does the IS curve shift? e. If the expected rate of inflation were to decrease from 3% to 2%, does the LM curve shift? f. If the risk premium on risky bonds increases from 5% to 6%, does the LM curve shift? g. If the risk premium on risky bonds increases from 5% to 6%, does the IS curve shift? h. What are the fiscal policy options that prevent an increase in the risk premium on risky bonds from decreasing the level of output? i What are the monetary policy options that prevent an increase in the risk premium on risky bonds from decreasing the level of output? IS Figure 6-6 Financial Shocks Monetary Policy,and Ohutput IS If sufficiently large, a decrease in the policy rate can in prin- ciple offset the increase in the risk premium. The zero lower bound may however puta limit on the decrease in the real policy rate LM 0 MyEconLab Animation LM Output, Y

Explanation / Answer

a) Real interest rate is the unit on vertical axis.

b) real interest rate= nominal interest rate- inflation rate

= 5 - 3= 2%

Value on vertical axis is 2%

c) new real interest rate= 5-2= 3%

Central bank can reduce nominal interest rate by 1% so that real interest rate is 2%.

d) IS curve does shift. IS curve is a function of consumption, investment, government expenditure and net exports. Investment is function of real interest rate. Higher the real interest rate lower is the investment. When inflation rate decreases, real interest rate rises. Increase in real interest rate reduces investment and thus shifts the IS curve to the left.

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