Question

2. [10 points] Explain in detail what effect a Fed purchase of bonds will have on: (1) the LM curve; and (2) the IS curve. 3. [10 points] Use the IS-LM model to answer this question. Suppose there is a simultaneous increase in taxes and red uction in the money supply. Explain what effect this particular policy mix will have on output and the interest rate. Based on your analysis, do we know with certainty what effect this policy mix will have on investment? Explain.

Answer 1

(2)

A fed purchase of bonds will increase money supply, shifting money supply curve rightward. So LM curve will shift rightward.

An increase in money supply will initially impact the money market only, and goods market will remain unaffected. Therefore IS curve will not change.

(3)

An increase in tax decreases consumption and savings, so IS curve shifts leftward, decreasing interest rate and decreasing output. At the same time, reduced money supply shifts LM curve to left, increasing interest rate and decreasing output. The net effect is a definite decrease in output. But effect on interest rate is uncertain. Since change in interest rate is uncertain, effect on investment is uncertain too.

In following graph, IS0 and LM0 are initial IS and LM curves intersecting at point A, with initial interest rate r0 and output Y0. When IS0 shifts left to IS1 and LM0 shifts left to LM1, they intersect at point B with lower output Y1 and new interest rate r1.

LM LMO 150 - Yo lis Yo