An economy with constant prices is described by an extended IS-LM model - that is, by an IS-LM model based on the following additional assumptions: - The central bank can set the real rate r, that therefore becomes the "policy rate" determined by monetary policy, and keeps it at the chosen level - Spending decisions (in particular investment decisions by firms) depend on the "real borrowing rate" r+x, sum of the real policy rate and the risk premium (x). Starting from an initial equilibrium position, suppose that the government cuts net taxes T and that at the same time the risk premoium x goes down. The central bank changes the policy rate to prevent these changes in T and x from affecting equilibrium production, that therefore remains unchanged. In the move from the initial equilibrium to the one that will be reached following the changes in x, T and r described above, the "real borrowing rate" r+x will have gone up, down or will have remained unchanged? Explain why.
An economy with constant prices is described by an extended IS-LM model - that is, by an IS-LM model based on the following additional assumptions:
- The central bank can set the real rate r, that therefore becomes the "policy rate" determined by
- Spending decisions (in particular investment decisions by firms) depend on the "real borrowing rate" r+x, sum of the real policy rate and the risk premium (x).
Starting from an initial equilibrium position, suppose that the government cuts net taxes T and that at the same time the risk premoium x goes down. The central bank changes the policy rate to prevent these changes in T and x from affecting equilibrium production, that therefore remains unchanged. In the move from the initial equilibrium to the one that will be reached following the changes in x, T and r described above, the "real borrowing rate" r+x will have gone up, down or will have remained unchanged? Explain why.
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