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Under the liquidity trap, money demand becomes very flat at low-interest rates. For this problem, consider the money demand function to be horizontal at a zero nominal interest rate.

A. Draw the LM curve. How does the slope of the curve change when the interest rate rises above zero?

B.Draw the IS curve. Does the shape of the curve change (necessarily) when the interest rate falls below zero?

C.Draw the AD curve? (Hint: From the IS-LM diagram, think about the price level at which the interest rate is zero. How does the AD curve look above this price level? How does the AD curve look below this price level?)

D.Draw the AD and AS curves and assume that equilibrium is at a point where output is below the natural level of output and where the interest rate is zero. Suppose the central bank increases the money supply. What will be the effects on output in the short run and the medium run? Explain in words.

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Divya Singh
Divya SinghLv10
28 Sep 2019

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Related questions

Consider an economy described by the following equations: C = 200 + 0.75(Y-T) where I = 200 - 25r, G = 100, T = 100, L(r, Y) = Y - 100r M = 1000 P = 2

(a) Derive the equation for the IS curve

(b) Derive the equation for the LM curve.

(c) What are the equilibrium interest rate r and the equilibrium level of output Y?

(d) What is the government purchases multiplier?

(e) What is the tax multiplier?

(f) Suppose that government purchases are raised from 100 to 150. How does the IS curve shift? What are the new equilibrium interest rate and level of output?

(g) Suppose instead that the money supply is raised from 1,000 to 1,200. How does the LM curve shift? What are the new equilibrium interest rate and level of output?

(h) With the initial values for monetary and fiscal policy, suppose that the price level rises from 2 to 4. What happens? What are the new equilibrium interest rate and level of output?

a) In the AD-AS model, stagflation does not persist, because the working of the self-correcting mechanism of the economy _____ the level of output and _____ the price level until the economy eventually returns to a long-run equilibrium state, where actual output _____ potential output.
decreases; decreases; falls short of
increases; decreases; equals
decreases; increases; exceeds
decreases; increases; equals
increases; decreases; exceeds
b) The LRAS curve is drawn as a vertical line at potential output (Y*) to indicate that
Y* is independent of the price level and that actual output Y > Y* in the long run
Y* equals actual output (Y) in the long run
Y* is independent of the price level and that actual output Y = Y* in the long run
Y* is independent of the price level
Y* is independent of the price level and that actual output Y < Y* in the long run
c) Stagflation arises in the context of the AD-AS model when some external factor causes
the LRAS curve to shift to the right
the AD curve to shift leftwards
the SRAS curve to shift downwards
the SRAS curve to shift upwards
the AD curve to shift rightwards
d) If the SRAS curve is positively sloped, then a decrease in the demand for Canadian-made goods in Europe will lead to _____ in the price level, in the short run.
either an increase or a decrease
no change
an increase
a decrease
an initial increase, and then a decrease
e) Which of the following will shift the aggregate demand curve to the right?
Consumers become pessimistic about the future
A new technology is developed that will increase profits
Income taxes are raised
Foreign economies fall into recession, reducing their demand for domestic exports
The government reduces purchases to balance the budget
f) Suppose a stock market crash decreases the stock of household wealth and therefore causes autonomous consumption to fall. Which of the following is the likely result?
A leftward shift the AD curve
There will be no movement of the AD curve
A movement down the AD curve
A movement up the AD curve
A rightward of the shift the AD curve
g) An economy is characterized by the AD equation P = 200 ? 0.02Y, SRAS equation P = 100 and LRAS equation Y* = 5000. In the absence of any change in policy or exogenous shocks, this economy will achieve a long-run price level of
100
110
120
90
105
h) The AD-AS model depicts a self-correcting economy. This means that the price level in the model adjusts automatically in response to a(n) _____ gap, so as to eliminate the _____ gap in the long run, without requiring any help from government policies.
recessionary; recessionary
recessionary; expansionary
expansionary; expansionary
output; output
expansionary; recessionary
i) The aggregate demand curve shows
the amount of planned aggregate expenditure (and output) at the current price level
the amount of planned aggregate expenditure (and output) at an average price level
the amount of planned aggregate expenditure (and output) at a constant price level
the amount of planned aggregate expenditure (and output) at various price levels
the amount of planned aggregate expenditure (and output) at last year's price level
j) Consider an economy initially at long-run equilibrium with output (Y) equal to potential output (Y*). If the SRAS is positively sloped, then a shift to the right of the AD curve will lead to _____ in the price level, in the short run. In the long run, the SRAS curve will shift to the _____ and the equilibrium will be at __________.
an increase; left; Y = Y*
a decrease; right; Y > Y*
an increase; right; Y = Y*
a decrease; left; Y > Y*
no change; left; Y = Y*

A typical AS curve has three parts: a flat, horizontal portion at low levels of output, a middle section with a more-or-less gentle upward slope, and a steep or vertical portion at high levels of output. Let's consider two of these parts individually, the horizontal portion and the vertical portion.

A. Imagine that AS and AD intersect in the horizontal portion of the AS curve. In this case, if aggregate demand increases, how does the output of the economy change? Does demand drive the economy here? (5 points)

B. Imagine that AS and AD intersect in the vertical portion of the AS curve. In this case, if aggregate demand increases, how does the output of the economy change? Does demand drive the economy here? (5 points)

C. Imagine that AS and AD intersect in the vertical portion of the AS curve. Assume a technological breakthrough increases the full-employment level of RGDP and shifts the AS curve to the right. In this case, when aggregate supply increases, how does the output of the economy change? Does supply create its own demand? (5 points)

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