Consider the economy which has been described as follows: a. If the nominal inte
ID: 1132998 • Letter: C
Question
Consider the economy which has been described as follows:
a. If the nominal interest rate is 3%, and the exptected inflation rate is 5%, What is the value of the vertical intercept of the LM Curve?
b. If the expected rate of inflation were to decrease from 5% to 1%, does the IS or LM Curve shift? If one of the 2 does not shift then why not?
c. If the premium on risky bonds increases from 3% to 6%, does the IS or LM curve shift? If one of the 2 does not shift then why not?
d. What are the fiscal policy options that prevent the changes on the level of output from above events (b and c)
e. What are the monetary policy options that prevent changes on the level of output from above events (b and c)
Explanation / Answer
a. When nominal policy rate is 5% and the expected rate of inflation is 3%, the real policy interest rate equals 2% i.e. value for the vertical intercept of the LM curve
b. The IS curve position depends on the real borrowing interest rate. Thus the expected inflation does not change that rate because it is part of the definition of a real rate of interest thus IS or LM Curve does not shift
c. The LM curve at the real policy rate is horizontal, which does not include the risk premium, thus an increase in the risk premium will not shift the LM curve.
At a given level of the real policy rate, a rise in the risk premium increases the real borrowing rate which reduces the planned investment, and thus IS curve shifts to the left (or shifts down)
d. If a rise in the risk premium leads IS curve to shift to the left, then a reduction in taxes or a rise in government spending could be used to shift the IS curve back to the right by an equal amount to ensure that the output level does not change.
e. If a rise in the risk premium leads IS curve to shift to the left, then the central bank could reduce the real policy rate by an amount sufficient to keep the output level from changing