Question

How can the Fed influence the location of the LM curve and the interest rate?

To help answer this question, assume that the demand for real balances is given by

(1) (M/P)d = 0.5Q ‑40i

and that money supply is initially fixed at

(2) (M/P)s = 400. (since prices are fixed you may assume P=1).

If money supply were increased to 500, and real output Q were constant at

(3) Q = 1600,

How would the intercept of the LM curve change? What would be the nominal rate of interest ?

6. What are the “crowding-out effects” that limit the effectiveness of fiscal and monetary policy to stimulate the economy under the IS-LM mechanism? Specifically:

a. How would the interest elasticities of the demand for investment and money affect the efficacy of fiscal vs. monetary policies?

b. How would uncertainty about expected future taxes and regulations that increase labor costs to firms affect “autonomous” investments (the constant term in the investment demand function) and equilibrium output?

c. How do financial regulations on banks about bank capital adequacy and leverage, risk management, and reporting requirement affect equilibrium Q?

Answer 1

(1st Question)

(M/P)d = 0.5Q - 40i

(M/P)s = 400

In money market equilibrium, (M/P)d = (M/P)s.

0.5Q - 40i = 400

0.5Q = 400 + 40i

Q = 800 + 80i........(Equation of LM curve)

When Q = 1600,

1600 = 800 + 80i

80i = 800

i = 10

When Q = 0, i = -800/80 = -10 (Vertical intercept of LM curve)

When (M/P)s = 500,

0.5Q - 40i = 500

0.5Q = 500 + 40i

Q = 1000 + 80i........(Equation of LM curve)

When Q = 1600,

1600 = 1000 + 80i

80i = 600

i = 7.5

When Q = 0, i = -1000/80 = -12.5 (Vertical intercept of new LM curve)

Therefore, when money supply increases, interest rate decreases (7.5% < 10%), and vertical intercept of LM curve decreases (-12.5 < -10), signifying a rightward shift of LM curve.

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