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1) A liquidity trap occurs when monetary policy becomes ineffective due to private agents being willing to hold any amount of money at the current interest rate, causing the LM curve to become perfectly elastic. 2) Crowding out occurs when higher government spending reduces private sector spending and investment by the same amount due to higher interest rates from increased government borrowing. 3) With a vertical LM curve where money demand does not depend on interest rates, fiscal policy affects only the interest rate while monetary policy affects output.

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59 views

Assignment

1) A liquidity trap occurs when monetary policy becomes ineffective due to private agents being willing to hold any amount of money at the current interest rate, causing the LM curve to become perfectly elastic. 2) Crowding out occurs when higher government spending reduces private sector spending and investment by the same amount due to higher interest rates from increased government borrowing. 3) With a vertical LM curve where money demand does not depend on interest rates, fiscal policy affects only the interest rate while monetary policy affects output.

Uploaded by

Mariam
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Mariam Jabbar

07288

Dornbusch and Fischer


Chapter 11

Conceptual questions
Answer 3
A liquidity trap is a situation in which monetary policy becomes ineffective because the
policymaker’s attempt to influence nominal interest rates in the economy by altering the
nominal money supply is frustrated by private agents’ willingness to accept any amount
of money at the current interest rate. The traditional theory of the liquidity trap assumed
that the LM curve becomes perfectly elastic at some level of the nominal interest.
Answer 4
Crowding out occurs when government spending fails to increase overall aggregate
demand because higher government spending causes an equivalent fall in private sector
spending and investment.
The theory behind the crowding out effect assumes that governmental borrowing uses up
a larger and larger proportion of the total supply of savings available for investment.
Because demand for savings increases while supply stays the same, the price of money
(the interest rate) goes up. Crowding out begins to take effect when the interest rate level
reaches a point at which only the government can afford to borrow.
Answer 5
The LM curve represents the combinations of income and the interest rate at which the
money market is in equilibrium. If money demand does not depend on the interest rate,
then we can write the LM equation as
M/P = L(Y)
For any given level of real balances M/P, there is only one level of income at which the
money market is in equilibrium. Thus, the LM curve is vertical, as shown in the Figure.
Mariam Jabbar
07288

Fiscal policy now has no effect on output; it can affect only the interest rate.
Monetary policy is effective: a shift in the LM curve increases output by the full amount
of the shift.
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07288

Abel and Bernanke


Chapter 8
Answer 1
a.

b.
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c.
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Answer 2
a.

b.
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c.
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Answer 3
a. First, we’ll find the IS curve.
Sd = Y – Cd – G = Y – [200 + 0.8(Y – T) – 500r] – G
= Y – [200 + (0.6Y – 16) – 500r] – G
= –184 + 0.4Y + 500r – G

Setting Sd = Id gives –184 + 0.4Y + 500r – G = 200 – 500r.


Solving this for Y in terms of r gives Y = (960 + 2.5G) – 2500r.
When G = 196, this is Y = 1450 – 2500r.

Next, we’ll find the LM curve.


Setting money demand equal to money supply gives 9890/P = 0.5Y – 250r – 25,
which can be solved for Y = 19,780/P + 50 + 500 r.
With full-employment output of 1000, using this in the IS curve and solving for r
gives r = 0.18.
Using Y = 1000 and r = 0.18 in the LM curve and solving for P gives P = 23.
Plugging these results into the consumption and investment equations gives C =
694 and I = 110.
Mariam Jabbar
07288

Answer 4
a. First, look at labor market equilibrium.
Labor supply is NS = 55 + 10(1 – t)w.
Labor demand (ND) comes from the equation w = 5A – (0.005A × ND).

Substituting the latter equation into the former, and equating labor supply and
labor demand gives N = 100.
Using this in either the labor supply or labor demand equation then gives w = 9.
Using N in the production function gives Y = 950.

b. Next, look at goods market equilibrium and the IS curve.

Setting Sd = I d gives – 284 + 0.6Y + 200r – G = 258.5 – 250r.


Solving this for r in terms of Y gives r = (542.5 + G)/450 – 0.004/3Y.
When G = 50, this is r = 1.317 – 0.004/3 Y.
With full-employment output of 950, using this in the IS curve and solving for r
gives r = 0.05. Plugging these results into the consumption and investment
equations gives C = 654 and I = 246.

c. Next, look at asset market equilibrium and the LM curve.


Setting money demand equal to money supply gives 9150/P = 0.5Y – 250(r +
0.02), which can be solved for r = [0.5Y – (5 + 9150/P)]/250.
With Y = 950 and r = 0.05, solving for P gives P = 20.

d. With G = 72.5, the IS curve becomes r = 1.367 – 0.004/3 Y.


With Y = 950, the IS curve gives r = .10, the LM curve gives P = 20.56, the
consumption equation gives C = 644, and the investment equation gives I = 233.5.
The real wage, employment, and output are unaffected by the change.

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