Question

1. Use the IS-LM model to show how an unexpected inflation could result in a higher short-run GDP.

2. Use the IS-LM model to show how an expected inflation could result in a higher short-run GDP. Explain using an IS-LM diagram. Make sure you explain in words what happens in your diagram.

3) Suppose a closed economy is initially in the long run equilibrium.

Suppose the monetary base of this economy is $100 million, of which people carry $10 million in form of currency/cash.

a). Assuming the banks keep a reserve ratio of 5%, what is the money supply in this economy?

Answer 1

1) The unexpected inflation will shift the LM curve to right. This will increase the short run GDP and it will reduce the price level. This shows the Pigou effect. The effect of unexpected inflation explains in the debt deflation theory. This will reduce the price level. LM Interest rate LM' iO i1 IS YO Y1 Output The fall in interest rate through unanticipated inflation will increase the investment rate and short run GDP. This will lead to economic growth and it will raise the employment rate also. 2) If there is expected inflation the IS curve will shift to right. This will raise the interest rate at the same time there is rise in output level. The rightward shift of IS curve increase interest rate. But the households and business firm were save a certain amount of reserve early, because of this expected inflation. So the consumption expenditure will be maintained through the early savings. This will maintain the level of output in the economy. LM i1 iO IS' IS YO Y1 Output 3) If the banks reserve 5 percent as reserve ratio. From this the rest of 95 percent used for lending purposes. This 95 percent will be used for business purposes and lending for households. Every banks should keep a certain level of money as reserves for unanticipated purposes.