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1. Consider an economy with zero interest rate and aggregate output less than its natural output (liquidity trap). a. Draw IS

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Answer #1

As per the HOMEWORKLIB POLICY, answering the first four parts only.

a.

Figure 1 below shows the situation of a liquidity trap in the economy. Initially, there is a negative shock to the Aggregate Demand because of which the IS curve shifts left from IS to IS`. This shift is enough to bring the economy into a liquidity trap. Liquidity trap situation is shown by point C. This point shows the intersection of new IS curve and the horizontal axis. At this point, the interest rates are zero and the aggregate output is less than the natural output Yn.

b.

The economy is represented by Figure 2 both panel (a) and panel (b). In case of liquidity trap, the AD curve after some range becomes completely vertical shown at point A, B, C. Any price movement will not affect the level of output attained.

c.

Price adjustment mechanism will not work as the Aggregate Demand is not responsive to the price change as well as to the changes in real money stock. Refer to Figure2 panel (b) Since, the output is below natural level, the AS curve shifts gradually from AS to AS1 and then to AS2 as low output means high unemployment and downward pressure on wage. However, the price level decreases, the output remains unchanged. So, its a failure of price adjustment mechanism.

d.

Expansionary Monetary Policy is needed to reduce unemployment and increase the output level. However, in case of a liquidity trap, this policy won't work.

This policy shifts the LM curve to the right so much so that natural level of output is attained.

Figure 3 shows the effect of monetary policy.

interest rate ---OXA Z ! Is Figun 1 D en b AS Ta TAD Figure 2 Yoyz LM V LM, 19 UTC

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