Question

Suppose from now on that because of a virus, people become afraid of using currency and decide to deposit all the currency in banks, and carry money exclusively in the form of demand deposits 4. What happens to the money supply? 5. Use the IS-LM model to illustrate the short run impact of this change in money supply on the equilibrium level of GDP and interest rate. Use a diagram and also explain in words. Make sure you show which curve shifts, and in which direction. Page 1 of 4 6. Assuming the fiscal and monetary policymakers do not do anything, what will be the long run level of GDP and interest rate? Use the same diagram you already drew to answer question 5. Make sure you show which curves shift, in what direction and what causes the shift 7. Assuming the government decides to stabilize output, what kind of fiscal policy should it use? Illustrate the effect on GDP and interest rate in the same diagrams you drew to answer questions 5 and 6. 8. Assuming the government decides to stabilize the interest rate what kind of fiscal policy should it use? Illustrate the effect on GDP and interest rate in the same diagram you drew to answer questions 5.6 and 7 Note: if your diagram is too small you might draw a larger better diagram The quality of your answer will depend greatly on how neat the diagram is

Answer 1

4. When people start depositing money in the bank, the excess reserves of the banks increase. The banks loan out create more money. Thus money supply rises.

5. This shifts the LM curve right from LM1 to LM2. This happens as real money balance rises. M/P increases - P being unchanged in short run. This decreases competition for lonable funds and interest rates falls from r1 to r2. While output rises from Y1 to Y2 because lowering of interest rates increases investment and consumption spending along the IS curve from e1 to e2. New equilibrium is at e2.

6. As aggregate demand is higher, firms will start producing more and will do so in expectation of rising prices. So in the long run, prices rise and the real money balance falls. This means the LM curve shifts back to the initial position until the aggregate demand reaches the initial (assuming that is the full employment level for this excercise) level of e1 equilibrium. Interest rates fall back to r1 and output falls back to Y1.

7. Now due to rise in money supply, output had rises and interest rate had fallen. If the government wants to stabilize output it will want to use a contractionary fiiscal policy. Such a policy (e.g. tax raise) will decrease aggregate spending and IS curve shifts left from IS1 to IS2'. This cause output to stabilize at the initial level of Y1 while interest rates are lower at r3. The equilibrium is at e2'.

8. However if government wants to stabilize interest rates, it would have to raise interest rates from r2 to r1. To do so it will have to apply a expansionary fiscal policy (e.g increase in G). This will increase aggreagate spending and raise interest rates to its initial level of r1. The new IS curve will be IS2'' at equilibrium e2''. However this will increase output further to Y3.

(there is a trade off in what the government wants to stabilize. When stabilizing interest rates, output rise higher than potential levels and will cause inflation. While in stabilizing output, interest rates fall substantially and can decrease real returns).