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(ECON199)[2010](s)midterm~id-^_10235.pdf
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2010 Midterm Partial Answer Key

Part B: Short Answer Questions:

1. a) First, explain what this action implies for the change of nominal money supply.

A Fed purchase of bonds will cause an increase in the money supply.

b) Explain in graph what effect Fed's purchase of bonds will have on: (1) the LM curve; and (2) the IS curve.

This will cause an excess supply of money and the interest rate must fall to restore money market equilibrium. The LM curve will shift down as a result of this to reflect the now lower interest rate. The IS curve does not shift as a result of this. We would simply observe a movement along the IS curve.



c) Compared to the old equilibrium point, what will happen to the interest rate and the output in the new equilibrium? If there is no IS curve, what will happen? Why the equilibrium point (the intersection of the IS and LM curve) implies a different level of interest rate and output than the case where there is only financial market equilibrium? (Hint: Use graphs to illustrate). Explain using economic intuition.

i is lower and Y is higher. If no IS curve, no change in Y, and i is even lower. The reason is now we consider both the goods and the financial market equilibrium. So when i decreases, from the goods market, investment is higher, which increases the national income Y, which in turn increases the real money demand. So the new equilibrium is at a higher i and higher Y compared to the case with only LM curve.


2). See Attached answer key.


i

LM

If no IS and Y not changed, i is lower than part b

Y

LM

i

i

Y

IS

i bb

Y b