MAE312 National Economic Policy - Macroeconomics Assignment Help

Question # 1:

IS-LM (Investment Savings-Liquidity preference Money supply) model majorly focuses on the equilibrium of the market of money and market of goods and services. It explains the relationship between the interest rates and the real output (Romer, 2000).

IS the curve for the goods and services market:

In the closed economy, Y represents the production for the market of goods and it is equal to the demands of the goods in the market. Y is the sum of public spending and consumption. This relationship represents the IS curve. IS curve has a negative slope as it has a negative relationship between the interest rate and the production (Vroey, 2000).

LM the curve for the money market: 

The curve LM shows the relationship between money and liquidity. In the closed economy, the equilibrium of demand and supply determines the rate of interest. The LM curve has a positive slope as it has a positive relationship between the output and the interest rate (Romer, 2000). 

To any point of the IS and LM curves, in the corresponding market, the condition of equilibrium is true. The condition of equilibrium is when the two curves are and LM intersects at some point. Many factors have an impact on both IS and LM curves such as different economic policies. For example, If government spending increases commonly known as a fiscal policy it will shifts the IS curve to the right (King, 2000), as it is shown in the below graph (fig. 1.1). This is due to the increase in government spending which results in more production for any interest rate. The shift of the IS curve may lead to the change in equilibrium point that is from point E1 to E2 with greater interest rates and also with the greater level of output (Goodhart, & Hofmann, 2005).

On the other hand, while considering the monetary policy that is an increase in the supply of money leads to shifting the LM curve to the right as it is shown in the below graph (fig. 1.2). Increase in the supply of money results in the decrease in interest rates (Colander, 2004).

If the central bank keeps the interest rates unchanged, the expected inflation rises and the real interest rate has fallen (Commonly we consider both expected inflation and inflation (and indeed often prices) as fixed in the short run). The fall in the real interest results in the shift of LM curve to the right (it is due to the increase in the expected inflation); this result in the equivalent monetary stimulus, which raises output by using the usual channels … until inflation rises in order to end the short run and the economy enters in the long run (Woodford, 2011).

Question # 2:

It is essential to note that at what extent the monetary policy impacts on the output level. Transmission of changes in the supply of money has some basic and essential steps which can be run as follows. In its first step, the increase in the supply of money results in a decrease in the interest rate. In its second step, the decline in the interest rate leads to an increase in the aggregate demand or total spending (Clarida, Gali, & Gertler, 2000). Consequently, the aggregate output modifies the changes in the aggregate demand. However, there are some of the links that do not work in the transmission process of changes in the money supply (Woodford, 2001).