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IS-LM diagrams

Suppose that the Fed pursues a policy of adjusting reserves to keep the interest rate fixed no matter what shocks hit the economy. With the help of IS-LM diagrams, explain how the Fed would react:

a. If foreigners buy fewer goods and services from the United States because of recessions in their countries.
b. If wealth holders in the United States reduce their demand for securities and increase their demand for money (bank deposits) because of increased risk aversion.
c. Based on your answer to a and b, do you think that the policy of keeping the interest rate fixed is desirable? Explain.

Solution Preview

a. See the attached file "a". The IS curve is in red and the LM curve is in blue. When foreigners buy fewer goods, it shifts the IS curve leftward. Interest rates fall as GDP contracts. The Fed would need to decrease the money supply, shifting the LM curve inward, to keep interest rates at the previous level.

b. A reduced demand for securities is a change in liquidity preference at all interest rates. By increasing the demand for ...

Solution Summary

IS-LM diagram use to explain Fed reactions to different scenarios.