a, b, c **Fig. 6: Financial Shocks and Monetary Policy Response**A sufficient decrease in policy rate can be enough to offset the increase in risk premium and restore initial output. The zero lower bound may however put a limit on the decrease in $ r $.**Graph Explanation:**The graph illustrates the interaction between financial shocks and monetary policy, specifically focusing on policy rate adjustments. - **Axes:** - The vertical axis represents the Policy rate, $ r $. - The horizontal axis represents Output, $ Y $.- **Curves:** - **IS and IS' Curves:** These downward-sloping curves represent the Investment-Saving (IS) relationship. The IS curve shifts left to IS' due to an increase in the risk premium. - **LM and LM' Curves:** These horizontal lines represent the Liquidity Preference-Money Supply (LM) relationship at different levels of $ r $.- **Points:** - **Point A:** Intersection of the original IS and LM curves, showing initial equilibrium at output $ Y $ and policy rate $ \overline{r} $. - **Point A'':** New equilibrium point after policy rate adjustment, with decreased rate $ \overline{r}' $, illustrating restored output at $ Y $.The graph highlights how a decrease in the policy rate can counterbalance a shift in the IS curve, contingent on the zero lower bound limiting further rate cuts. ## Topic II: Analyzing an Economic Model### Consider an economy as depicted in Figure 6 on page 19 of Chapter 6 slides:#### Questions:a. **Nominal Policy Interest Rate Adjustment** - If the nominal policy interest rate is 5% and expected inflation decreases from 3% to 2%, what action must the central bank take regarding the nominal policy rate to prevent the LM curve from shifting as shown in Figure 6?b. **Risk Premium Impact on LM Curve** - Does an increase in the risk premium on risky bonds from 5% to 6% cause the LM curve to shift?c. **Risk Premium Impact on IS Curve** - Does an increase in the risk premium on risky bonds from 5% to 6% cause the IS curve to shift?d. **Fiscal Policy Options** - What fiscal policy measures can prevent an increase in the risk premium on risky bonds from decreasing the level of output?e. **Monetary Policy Options** - What monetary policy measures can prevent an increase in the risk premium on risky bonds from decreasing the level of output?### Graphs and Diagrams- **Figure 6 Explanation** - While the figure itself is not provided in this transcription, Figure 6 is expected to illustrate the effects of interest rate changes and risk premiums on the LM and IS curves. It likely shows how these variables interact with macroeconomic stability and output levels within an economy.

“Since you have posted a question with multiple sub-parts, we will solve first three sub-parts for…

Fig.6: Financial Shocks and Monetary Policy Response A sufficient decrease in policy rate can be enough to offset the increase in risk premium and restore initial output. The zero lower bound may however put a limit on the decrease in r. IS IS' A LM Y LM’ A" Output, Y Policy rate, r

Fig.6: Financial Shocks and Monetary Policy Response A sufficient decrease in policy rate can be enough to offset the increase in risk premium and restore initial output. The zero lower bound may however put a limit on the decrease in r. IS IS' A LM Y LM’ A" Output, Y Policy rate, r

ENGR.ECONOMIC ANALYSIS

14th Edition

ISBN:9780190931919

Author:NEWNAN

Publisher:NEWNAN

Chapter1: Making Economics Decisions

Section: Chapter Questions

Problem 1QTC

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Question

a, b, c

**Fig. 6: Financial Shocks and Monetary Policy Response**

A sufficient decrease in policy rate can be enough to offset the increase in risk premium and restore initial output. The zero lower bound may however put a limit on the decrease in $ r $.

**Graph Explanation:**

The graph illustrates the interaction between financial shocks and monetary policy, specifically focusing on policy rate adjustments.

- **Axes:**
- The vertical axis represents the Policy rate, $ r $.
- The horizontal axis represents Output, $ Y $.

- **Curves:**
- **IS and IS' Curves:** These downward-sloping curves represent the Investment-Saving (IS) relationship. The IS curve shifts left to IS' due to an increase in the risk premium.
- **LM and LM' Curves:** These horizontal lines represent the Liquidity Preference-Money Supply (LM) relationship at different levels of $ r $.

- **Points:**
- **Point A:** Intersection of the original IS and LM curves, showing initial equilibrium at output $ Y $ and policy rate $ \overline{r} $.
- **Point A'':** New equilibrium point after policy rate adjustment, with decreased rate $ \overline{r}' $, illustrating restored output at $ Y $.

The graph highlights how a decrease in the policy rate can counterbalance a shift in the IS curve, contingent on the zero lower bound limiting further rate cuts.

## Topic II: Analyzing an Economic Model

### Consider an economy as depicted in Figure 6 on page 19 of Chapter 6 slides:

#### Questions:

a. **Nominal Policy Interest Rate Adjustment**
- If the nominal policy interest rate is 5% and expected inflation decreases from 3% to 2%, what action must the central bank take regarding the nominal policy rate to prevent the LM curve from shifting as shown in Figure 6?

b. **Risk Premium Impact on LM Curve**
- Does an increase in the risk premium on risky bonds from 5% to 6% cause the LM curve to shift?

c. **Risk Premium Impact on IS Curve**
- Does an increase in the risk premium on risky bonds from 5% to 6% cause the IS curve to shift?

d. **Fiscal Policy Options**
- What fiscal policy measures can prevent an increase in the risk premium on risky bonds from decreasing the level of output?

e. **Monetary Policy Options**
- What monetary policy measures can prevent an increase in the risk premium on risky bonds from decreasing the level of output?

### Graphs and Diagrams

- **Figure 6 Explanation**
- While the figure itself is not provided in this transcription, Figure 6 is expected to illustrate the effects of interest rate changes and risk premiums on the LM and IS curves. It likely shows how these variables interact with macroeconomic stability and output levels within an economy.

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