Question

6. Consider the IS-LM model. The central bank uses the interest rate as its policy instrument....

6. Consider the IS-LM model. The central bank uses the interest rate as its policy instrument. Illustrate and explain the impact of the following shocks on the equilibrium values of real income/output, money stock, consumption, and investment.

A. The non-bank private sector lowers its currency holdings.

B. Households increase autonomous saving

C. Default risk premium declines

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Answer #1

a. decrease in currency holdings will lead to increase in money supply. as interest rate falls, investment will rise and output will also rise. so consumptin will also increase.

b. Increase in saving will lead to increase in money supply. as interest rate falls, investment will rise and output will also rise. effect on consumption is indeterminate.

c. as default risk premium declines, money demand will fall so nterest rate falls, investment will rise and output will also rise. so consumptin will also increase.

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