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Shifts in IS and LM curves

Suppose that both the stock market and housing prices fall in the U.S.

a. First, explain the channels through which these shocks affect aggregate demand for goods and services.
b. Second, with the help of an IS-LM graph, explain the effect of these shocks on 1) real GDP, 2) the interest rate, 3) the exchange rate and on 4) the composition of demand.
c. Suppose the Fed wants to use open market operations to offset the effect on real GDP. What would it do? With the help of an IS-LM diagram, explain the effects of Fed policy if it works.
d. Explain why Fed policy might not be effective.
e. Next, consider fiscal stimulus as an alternative to monetary stimulus. With the help of an IS-LM diagram, explain the effects of the fiscal stimulus that you choose.

Solution Preview

a. When housing and stock prices fall, it causes consumers to feel less wealthy. This "wealth effect" causes consumers to cut back on their spending. A decline in the demand for goods and services results. Consumers are of course less wealthy and cannot sell their assets for as much money, which prevents them from trading up to more expensive housing as they might normally want to. In addition, there is less collateral for them to use for borrowing.

b. The ...

Solution Summary

IS-LM graph used for solving questions on stock market, housing prices, and monetary policy

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