CHAPTER11MONETARYANDFISCALPOLICYSolutionstotheProblemsintheTextbook:ConceptualProblems:1.a.AnopenmarketoperationisanexchangeofbondsformoneyorviceversabytheFed.Inanopenmarketpurchase,theFedbuysbondsfromthepublic(generallyviagovernmentbonddealers)inexchangeformoney.Thisactionincreasesthemonetarybaseandthereforethesupplyofmoney.Inanopenmarketsale,theFedsellsbondsinexchangeformoney,decreasingthemonetarybaseandthereforethesupplyofmoney.1.b.WhentheFedundertakesopenmarketsales,itexchangesbondsformoney.Thisdecreasesthemonetarybaseandtheresultingdecreaseinmoneysupplycreatesaportfoliodisequilibrium.Thepublicadjustsbysellingotherassets,soassetpricesdecreaseandyields(interestrates)increase.Thisincreaseininterestrateshasanegativeeffectonaggregatedemand(investmentspending)andoutputcontracts.Alowerlevelofnationalincomereducesmoneydemandandthereforeinterestratesdeclineagain.Butifthepricelevelisassumedtobefixed(asintheIS-LMmodel),theninterestratesstillsettleatalevelhigherthantheoriginalone.Overall,inanIS-LMdiagram,theLM-curveshiftstotheleft,leadingtoahigherlevelofinterestratesandalowerlevelofincome.2.TheIS-curveisvertical,ifinvestmentspendingistotallyinterestinsensitive.Thisiscalledinvestmentinsufficiency;inthiscasethemonetarymultiplieriszero.Sincetheparameterbintheinvestmentequationequalszero,theequationchangesfromI=Io-bitoI=Io.AhorizontalLM-curvewillalsorendermonetarypolicyineffective.Thisiscalledtheliquiditytrap.Inthiscase,moneydemandistotallyinterestelastic,andtheparameterhinthemoneydemandequationisassumedtobeinfinitelylarge.ThefiscalpolicymultiplieriszeroiftheLM-curveisvertical.Thiscaseiscalledtheclassicalcase,andmoneydemand(andmoneysupply)isassumedtobetotallyinterestinsensitive.Sincetheparameterhinthemoneydemandequationequalszero,theequationchangesfromL=kY-hitoL=kY.Noneofthesethreecasesisverylikelytooccur.However,someeconomistsassertthatJapaninthelate1990’sandtheU.S.intheGreatDepressionwerein,orcloseto,theliquiditytrap.3.Aliquiditytrapisasituationinwhichthepubliciswillingt...
