CHAPTER 11 MONETARY AND FISCAL POLICY Solutions to the Problems in the Textbook

CHAPTER 11 MONETARY AND FISCAL POLICY Solutions to the Problems in the Textbook: Conceptual Problems: 1.a. An open market operation is an exchange of bonds for money or vice versa by the Fed. In an open market purchase, the Fed buys bonds from the public (generally via government bond dealers) in exchange for money. This action increases the monetary base and therefore the supply of money. In an open market sale, the Fed sells bonds in exchange for money, decreasing the monetary base and therefore the supply of money. 1.b. When the Fed undertakes open market sales, it exchanges bonds for money. This decreases the monetary base and the resulting decrease in money supply creates a portfolio disequilibrium. The public adjusts by selling other assets, so asset prices decrease and yields (interest rates) increase. This increase in interest rates has a negative effect on aggregate demand (investment spending) and output contracts. A lower level of national income reduces money demand and therefore interest rates decline again. But if the price level is assumed to be fixed (as in the IS-LM model), then interest rates still settle at a level higher than the original one. Overall, in an IS-LM diagram, the LM-curve shifts to the left, leading to a higher level of interest rates and a lower level of income. 2. The IS-curve is vertical, if investment spending is totally interest insensitive. This is called investment insufficiency; in this case the monetary multiplier is zero. Since the parameter b in the investment equation equals zero, the equation changes from I = Io - bi to I = Io. A horizontal LM-curve will also render monetary policy ineffective. This is called the liquidity trap. In this case, money demand is totally interest elastic, and the parameter h in the money demand equation is assumed to be infinitely large. The fiscal policy multiplier is zero if the LM-curve is vertical. This case is called the classical case, and money demand (and money supply) is assumed to be totally interest insensitive. Since the parameter h in the money demand equation equals zero, the equation changes from L = kY - hi to L = kY. None of these three cases is very likely to occur. However, some economists assert that Japan in the late 1990’s and the U.S. in the Great Depression wer