Question

need help on d-i

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? Policy rate, Figure 6-6 Financial Sharks. Monetary Policy and Chapel 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 put a limit on the decrease in the real policy rate. My EconLab Animation Output, Y

Answer 1

Answer:

In the IS-LM framework, the vertical axis measures the rate of interest. Thus, the unit of the vertical axis is in percentage (%).

It is given that the nominal policy interest rate is 5% and the expected inflation is 3%. Thus, the vertical intercept can be calculated by calculating the real interest rate as follows: Real Interest Rate -Nominal interest rate - Expected inflation Real Interest Rate - 5%-3% -2% Thus, the vertical intercept of LM curve is 2%.

The expected inflation has decreased from 3% to 2%. Any change in the expected inflation rate will impact the interest rate and the LM curve will shift. To prevent the LM curve from shifting, the central bank should lower the nominal interest rate. Real Interest Rate - Nominal interest rate - Expected inflation Ar = Ai-AIT 0 = Ai-AIT Ai=AIT Since the decrease in the expected inflation is by 1%, the nominal interest rate should decrease from 5% to 4%. Thus, the central bank should decrease the nominal interest rate by 1%, i.e., nominal interest rate should be changed to 4%.

d. The IS curve shows the combination of interest rate and the level of income which bring the goods and service market in equilibrium. The IS curve is downward sloping as there is a negative relationship between interest rate and output. When the expected inflation decreases from 3% to 2%, this affects the IS curve as the real rate of interest changes. Therefore, the IS curve does shift.

Like the part d, the change in the inflation rate affects the real policy rate and thus, due to the change in the inflation rate, the LM curve shifts.

As it can be seen from the diagram, the LM curve is a horizontal straight line at the real policy rate. Risk premium has nothing to do with the real policy rate, therefore, the change in the risk premium does not shift the LM curve.

IS curve is affected by the change in the real borrowing rate. An increase risk premium increases the real borrowing rate, given that the real policy rate is constant. Therefore, planned investment falls because of it and thus, the IS curve shifts to the left. Therefore, increase in the risk premium does shift the IS curve.

h. As seen above, an increase in the risk premium shifts the IS curve to the left. In such a case, a reduction in the taxes or increase in the government spending can help in shifting back the IS curve to its original position and thus, the output will not change.

Similarly, the monetary policy that can help in preventing the output to change will be if the central bank decreases the policy rate by the sufficient amount that keeps the output to its original position.