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IS-LM diagrams

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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.

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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 ...

Solution Summary

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

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IS/LM diagram

1. Draw an IS/LM diagram which shows a macro equilibrium (use the â??intermediate range for the LM curve --- assuming the absolute value of lâ?? is less than infinity and greater than 0). Indicate the equilibrium interest rate by ro, and the equilibrium level of income by yo.

2 . Now suppose there is an increase in government spending financed by the Treasury selling bonds to the public (a pure fiscal policy).
a) Show the appropriate shifts in the IS and/or LM curve in the above diagram.
b) Indicate the new equilibrium income and interest rate by y1 and r1.
c) State what has happened to equilibrium income and interest rates.
d) Is the level of investment spending higher or lower than at ro,yo?
e) Has money demand changed? If so, how?
f) If the LM curve had been totally inelastic (lâ??=0) with respect to interest rates (vertical) would your answers to b) and e) change? If so, how and why.

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