Question

4. Suppose the central bank wants to keep the real interest rate constant at some level, ř. Describe whether it needs to increase, decrease, or not change the money supply to do this in response to each of the following developments. Except in part (d), assume that P is permanently fixed at some exogenous level, P. a. The demand for money at a given P, i, and Y increases. b. There is an upward shift of the consumption function. c. The exogenous price level, P, increases permanently. d. Expected inflation increases (with no change in the current price level).

Answer 1

b) 1 Rate - Rate = --- TELE2 - Interest in Md Mo Money -lay (d) 1. Nationtal LM' Output .com Entero Rate is Output -st is Outbutt

a. An increase in the level of money demanded will shift the money demand curve rightwards to Md' and this increases the rate of interest in the money market. To prevent the rate of interest from rising, the Central Bank should increase the level of money supplied in the economy to Ms' which will keep the rate of interest constant at r.

b. An upward shift of the consumption function will also shift the IS curve upwards to IS' in the IS_LM model. Thus, to prevent rate of interest to increase and keep it constant at i1, the money supply in the economy should be increased and LM must shift rightwards to LM' and at the new equilibrium level, the rate of interest is constant.

c. An increase in price level will reduce the real money supplied in the economy and this will shift the LM curve leftwards to LM' and to prevent the rate of interest from increasing, the Central Bank should increase the level of nominal money supplied in the economy to move the equilibrium back to E1 with the same rate of interest.

d. In this case IS curve shifts leftwards and to prevent rate of interest from declining, the money supply should decrease which will shift the LM curve leftwards to LM' and keep the rate of interest constant.