Question

Given the normal IS-LM and AD-AS

(1) Show the effect of the increase of M by the government using graphs. (Be careful about intersection points in the graphs.) (2) Using total differentiation, calculate the first (only LM), second (IS-LM) and third multiplier (AD-AS) of the increase of money supply on Y, dY/dm = ?, and demonstrate these multipliers in the graphs. (3) Now, assume that we are in the liquidity trap. Demonstrate the graphs and calculate dY/dm again (4) How do you justify unconventional monetary policy such as quantitative eashing in this case? Show the change in equilibria in the IS-LM and AD-AS graph

DescriptionA liquidity trap is a situation, described in Keynesian economics, in which, "after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers holding cash rather than holding a debt which yields so low a rate of interest."

Answer 1

(1)

Increase in money supply will shift money supply curve to right, thus shifting LM curve to right, so Interest rate will decrease and output will increase.

In following graph, IS0 and LM0 are initial IS and LM curves, intersecting at point A with initial interest rate r0 and output Y0. Higher money supply shifts LM0 right to LM1, intersecting IS0 at point B with lower interest rate r1 and higher output Y1.

Lower interest rate increases consumption and investment, increasing aggregate demand, shifting AD curve rightward, which increases real GDP and increases price level.

In following graph, AD0 and SRAS0 are initial aggregate demand and short-run aggregate supply curves intersecting at point A with initial price level P0 and real GDP Y0. As aggregate demand increases, AD0 right left to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1.

SRASO Yo Y, Y

NOTE: As per Chegg Answering Policy, 1st question is answered.