Question

a. On two separate diagrams, draw the IS-LM graphs, one with a steep IS curve and the other with a flatter one. You might recall from our discussion of the extended IS-LM model that the slope of the IS curve depends on the sensitivity of I to interest rates. The central bank uses expansionary monetary policy to increase output. In which case is the policy more effective? Why (give an economic explanation, not a mathematical argument)? b. Okun's law estimated for the US is given by: | u-u-1 = -0.40g - 3%), where g is the current growth rate and u and u-1 are the current- and previous-period unemployment rates. How much higher than the normal growth rate of 3% does the current growth rate need to be to reduce the unemployment rate by 1%?

Answer 1

Celution a a. Steep IS Schedule b. Flat IS Schedule LMO LM 1 11 11 11 -----* YOY Yo Yi Steep Is schedule means that interest sensitivity of enuertiment is very low whereas a flatter Is curve means high interest sensitivity of the investment. Now, when, Erfansionary Monetary Policy is used , et offent encome by lowering the witerest rate and stimulating investment when envestment is cleus renitive to interest rates, investment only increases marginally , so does income. This is the case when IS aurre is eteefes deficiting low interest senisterity of investment. When on the other hand, Is curue is flatter, interest rensitivity of investment is greater an expansionary monetary policy a causing interest rates to go down will have greater impact 35 on investment and consequently on encome Therefore, because of above quies' season, Monetary Policy is more effective when IS curne is flatter.

H olun's law for us - u-u, = - 0-4 (g-3%) unemployment rate needs to be seduued by Lºlo ein current period then u-u, = -1 Okun's how becomes - = -0.4 (4 - 3) I = (9-3) 2.5 = 9-3 g= 2.+3 g= 5.5% Current grourth rate needs to at 5.5% i e, [2.5% higher than the normal growth rate.