Question

1. For each of the following situations, describe how (if at all) the IS, MP, and AD curves are affected.

a. A decrease in financial frictions.

b. An increase in taxes and an autonomous easing of monetary policy.

c. An increase in the current inflation rate.

d. A decrease in autonomous consumption.

e. Firms become more optimistic about the future of the economy.

2. What evidence is used to assess the stability of the money demand function? What does the evidence suggest about the stability of money demand, and how has this conclusion affected monetary policymaking?

3. Why is Keynes’s analysis of the speculative demand for money important to his view that velocity will undergo substantial fluctuations and thus cannot be treated as constant?

Answer 1

The IS curve represents the Investment Savings curve

The MP curve represents the Monetary Policy Curve

The AD curve represents the Average Demand curve

1 (a) A decrease in the financial friction causes the IS curve to shift right, the MP curve does not shift and the AD curve shifts rightwards.

(b) An increase in taxes causes the AD curve to shift leftwards and the IS curve remains constant.

However with autonomous easing of monetary policy, the AD curve shifts rightwards and the MP curve downwards

(c) An increase in current inflation rates causes the AD curve to increase,

(d) Firms becoming more optimistic on the economy causes the AD curve to shift upwards, IS curve to shift upwards and MP curve to increase.

2. The money demand refers to the desire to hold money in comparison to buying assets. The determinants to access the stability of money demand function are many. The determinants of stable money demand is a function of level of income, interest rates, inflation and certainty of the future.

The stability in the money demand function impacts the monetary policy making. If the money demand is stable in the economy then the regulators also stabilize the monetary policy which in turn helps people take better decision with respect to the money. Hence the stability of money demand have a direct impact on the monetary policy making.

3. Keynes analysis of speculative demand for money suggest that the velocity undergoes various fluctuations and is far from being constant. It explains that velocity is impacted by interest rates which are very volatile. Hence the velocity is also not constant and remains volatile.