II. Short Answer A. Create a graph of equilibrium in the IS-LM model. Show the effect of an expansionary monetary policy. Summarize your results.
Monetary Policy and Equation of Exchange
The monetary policy has been defined as the policy that is used by the Federal Reserve (the central bank of the US) or the central bank (the central bank of India is RBI) along with the use of the supply of money to accomplish certain macroeconomic policies. Monetary policy is a supply-side macroeconomic policy that supervises the growth rate and money supply in the economy.
Monetary Economics
As from the name, it is very evident that monetary economics deals with the monetary theory of economics. Therefore, we can say that monetary economics, is that part of economics that provides us with the idea or notion of analyzing money as a holding with its function, which acts as the medium of exchange, the store of value through which the buying and selling are done and also the unit of account. It also helps in formulating the framework of the monetary policy of a bank in an economy which ultimately results in the welfare of the people residing in that particular economy. The monetary policy of an economy also helps to analyze and evaluate the financial health of it.
II. Short Answer
A. Create a graph of equilibrium in the IS-LM model. Show the effect of an expansionary
IS-LM model was developed by John R Hicks and Alvin H Hansen. The Hicks-Hansen model combines the theory of income and output and the theory of money and interest in a two-market equilibrium model. IS-LM model shows how the product market and money market interact to determine the level of income and the rate of interest. It is a general equilibrium model because it shows the attainment of equilibrium simultaneously in the both product and money market.
RELATIVE EFFECTIVENESS OF MONETARY AND FISCAL POLICY:
Monetary policy is the exercise of the central bank's control over the money supply as an instrument for achieving the objectives of general economic policy.
Fiscal policy is the exercise of the government's control over public spending and tax collections for the same purpose.
The relative effectiveness of monetary and fiscal policies is compared based on their ability to raise the level of income. IS-LM framework can be used for comparing the relative efficiency of monetary and fiscal policies.
The LM curve slopes upwards to the right and has three segments. The perfect elastic segment is known as the 'Keynesian range". The perfect inelastic segment is known as the 'Classical range'. In between these two segments lies the 'Intermediate range'. The relative effectiveness of monetary and fiscal policies depends on the extent to which they effect the level of income and the rate of interest.
The Keynesian Range:
The perfectly elastic segment of the LM curve is known as the 'Keynesian range'. This is the liquidity trap phase and the rate of interest cannot fall below r1. An increase in the money supply shifts the LM curve to the right, from LM1 to LM2. An expansion in the money supply cannot cause the interest rate to fall below the rate given by the liquidity trap. Since money supply has no effect on the rate of interest, investment is not effected and the level of income remains unchanged at Y1.
The monetary policy is powerless to raise the level of income if the economy is in the liquidity trap. Thus monetary policy is completely ineffective in the Keynesian range.
The government can use the fiscal policy to raise the level of income in the Keynesian range. Fiscal measures such as increased government spending or reduced taxes will produce a shift in the IS curve to the right, from IS1 to IS2, Interest remaining constant at r1, the income level rises from Y1 to Y2. Thus fiscal policy is completely effective in raising the level of income in the Keynesian range.
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