Question

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Answer each question and explain your answer in the space provided.

4. (5 points) What effect a selling bonds will have on the money market? Explain using bond prices. 5. (7 points) Assume that fiscal policy can be accomplished by changing only one of G and T. In the IS-LM framework, suppose the effect on the general equilibrium output is the same between expansionary fiscal policy and expansionary monetary policy. Which one would you expect to have a greater impact on the equilibrium consumption? Explain in words. Hint: Monetary policy affects also affects Y in the IS-LM framework!

Answer 1

4. When bonds are sold in the market, then this means that bonds are being exchanged for money. The supply of bonds rise while money supply decreases. When supply of bonds rise, its prices fall. Now remember that the yeild for bonds depend on its starting price and interest rates and that the relation between price and interest rate on bonds have a inverse relationship. When prices fall, the final yield on the bonds fall and so interest rates have to rise to sustain the market. Thus we can summarize the impact as : selling of bonds - money supply fall - bonds price fall - interest rates rise.

5. Well given that the general equilibrium output remains same for both policies means that the economy always self stabilize and output returns to initial (potential) level. In case of a expansionary fiscal policy, in short run - output and interests rise. While in general equilibrium when output returns to intial level due to price adjustment mechanism, the interest rate rises further than the initial level. So in short run - consumption rise due to rise in output - however rise in interest rate crowds out some consumption. In long run - output returns to normal and based on this consumption would fall to initial level. However interest rates will be further higher and this can crowd out some more consumption and can lead to a decrease in equilibrium consumption in general equilibrium.

While expansionary monetary policy raises output and reduces interest rates. In short run output rises due to rise in`output and fall in interest rates. Here there is no crowding out in short run. Compared to exp. fiscal policy, consumption rises more (theoritically) in this case. In long run, prices will adjust and real money balance will fall. Output and interest rate both return to initial level. Consumptio levels will also theoritically decrease to the starting level.

So exp. monetary policy impact on short term equilibrium consumption is more than exp. fiscal policy. In long run there is no real impact on equilbrium consumption of exp. monetary policy. While exp. fiscal policy can lead long run equilibrium consumption to be lower due to real interest rate effects.