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11. Monetary policy and the LM curve Aa Aa The following graph shows the demand and supply of real money balances in a hypothetical economy. Use the black point (X point) to indicate the equilibrium in this market. Dashed drop lines will automatically extend to both axes. REAL INTEREST RATE [Percent) 10 Equilibrium Supply New Supply New Equilibrium Demand 3 0 10 20 30 40 50 60 70 80 90 100 REAL MONEY BALANCES Help Clear AlL Now suppose the central bank of this economy decides to real money balances is now 50. Use the green line (triangle symbols) to graph the new supply of real money balances, then use the red point (cross symbol) to indicate the new equilibrium in this market. Dashed drop lines will automatically extend to both axes. the money supply so that the supply of On the following graph, show the effect this change in monetary policy has on the LM curve for this economy. Tool tip: Click and drag the curve. The curve will snap into position, so if you try to move the curve and it snaps back to its original position, just try again and drag it a little farther. REAL INTEREST RATE LM INCOME, OUTPUT 12. Fiscal policy and the IS-LM model Aa Aa This problem asks you to analyze the effects of a change in fiscal policy according to the IS-LM model. It will walk you through the building blocks of the IS and LM curves to help you determine what changes in the model Consider a hypothetical closed economy where the marginal propensity to consume (MPC) is 0.5 and taxes do not depend on income level. Suppose taxes decrease by $20 billion in this economy. Complete the following tables with the effects that this has on the market for goods and services and the market for real money balances. Market for Goods and Services No Change IS Curve Determinants Planned Expenditure Equilibrium income from Keynesian cross model Increase Decrease No Change Right Shift Left Shift IS curve Market for Real Money Balances LM Curve Determinants Demand for real money balances Supply of real money balances No Change Increase Decrease No Change Right Shift Left Shift LM curve The tax multiplier is in this economy. The following graph shows the IS and LM curves for this economy prior to the change in fiscal policy. Use the black point (X symbol) to indicate the equilibrium in this model prior to the change in government purchases. Next, determine if the IS curve, the LM curve, or both shift in response to the $20 billion decrease in taxes. Use the green ine (triangle symbols) to graph the new IS curve if that curve shifts, use the purple line (diamond symbols) to graph the new LM curve if that curve shifts. Last, use the red point (cross symbol) to indicate the new equilibrium in this economy REAL INTEREST RATE (Percent 10 Initial Equilibrium LM New IS Curve New LM Curve New Equilibrium ISI 0 10 20 30 40 50 60 70 80 90 100 INCOME, OUTPUT (Billions of dollars Help Clear All Although the curve you just graphed shifted to theby only , the equilibrium level of income because of the change in the interest rate. by

Answer 1

11. Monetary policy and the LM curve Aa Aa The following graph shows the demand and supply of real money balances in a hypothetical economy. Use the black point (X point) to indicate the equilibrium in this market. Dashed drop lines will automatically extend to both axes. REAL INTEREST RATE [Percent) 10 Equilibrium Supply New Supply New Equilibrium 5 Demand 3 0 10 20 30 40 50 60 70 80 90 100 REAL MONEY BALANCES Help Clear All Now suppose the central bank of this economy decides to DECREASEthe money supply so that the supply of real money balances is now 50. Use the green line (triangle symbols) to graph the new supply of real money balances; then use the red point (cross symbol) to indicate the new equilibrium in this market. Dashed drop lines will automatically extend to both axes.

On the following graph, show the effect this change in monetary policy has on the LM curve for this economy. Tool tip: Click and drag the curve. The curve will snap into position, so if you try to move the curve and it snaps back to its original position, just try again and drag it a little farther. REAL INTEREST RATE LM ri LEFTWARD SHIFT OF THE LM CURVE DUE TO DECLINE IN MONEY SUPPLY Interest rates will increase due to declining money supply. cost of acquiring money will increase. IN INCOME, OUTPUT