ECO2004S Whiteboard Questions

17 August 2023

Question 1

Use the IS-LM model diagram to answer the following questions.

a. Draw an economy in equilibrium where the LM curve intersect the IS curve and the
output policy interest rate are at the equilibrium level.

b. If the nominal policy interest rate is 5% and the expected rate of inflation is 3%, what
is the value for the vertical intercept (policy interest rate) of the LM curve when the
economy is in equilibrium? (Indicate on the diagram you drew in question a).

c. Assume the economy is going through a recession and policy makers decide to
decrease the policy interest rate from 3% to 2% What will happen to borrowing real
interest rate and output in this economy? (Indicate on the diagram you drew for a
and b and substantiate your answer).

d. If expected inflation decreases from 3% to 2%, to keep the LM curve from shifting,
what must the central bank do to the nominal policy rate of interest?

e. If the expected rate of inflation decreases from 3% to 2%, with the nominal policy rate
unchanged, does the IS curve shift? (Substantiate your answer)

f. If the expected rate of inflation were to decrease from 3% to 2%, does the LM curve
shift? (Substantiate your answer)

g. If the risk premium on risky bonds increases from 5% to 6%, does the LM curve shift?
(Substantiate your answer)

h. If the risk premium on risky bonds increases from 5% to 6%, does the IS curve shift?
(Substantiate your answer)

i. Assume the economy is experiencing a boom and lenders grow less risk averse
resulting in a risk premium decrease from 9% to 6%. Using the IS-LM diagram explain
the impact of the decrease in the risk premium on the real borrowing interest rate and
equilibrium output.

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Answers
a.

b. Given that the real interest rate is equal to the nominal interest rate the value of the
intercept (policy interest rate is 2% (5% -3%).

c. If real policy interest decreases from 2% to 1% it will cause the real borrowing interest
rate to also decrease by 1%, and output to increase. Graphically, the reduction of
policy interest will cause downward shift of the LM curve, disturbing the equilibrium
in the economy. To return the economy to equilibrium adjustments will occur in the
IS relation. The real borrowing interest rate will decrease by 1% reducing the cost of
investments and thereby increase investments and by implication output in the
economy. This will be reflected as a downward movement to the right along the IS
curve to the new equilibrium, Point B where the LM and IS curves intersect, at a low
equilibrium real policy interest rate, real borrowing interest rate and higher
equilibrium level of output.

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d. The central bank would have to lower the nominal policy interest rate by 1%

e. No, the IS curve will not shift- the position of the IS curve depends on the real
borrowing interest rate. Expected inflation does change that rate since expected
inflation is part of the definition of a real rate of interest, but it will not shift the IS
curve.

f. No, the LM curve will not shift– the position of the LM curve is defined by the real
policy interest rate. A change in expected inflation does not shift that curve. The
central bank is taking expected inflation into account in setting a real policy interest
rate.

g. No, the risk premium does not shift the LM curve. It is horizontal at the real policy
rate of interest which does not incorporate the risk premium.

h. Yes. At the same real policy rate of interest, the real borrowing rate of interest
increases causing a decrease in investments and output. The IS curve shifts left (or
down) reflecting a decrease in investment and output.

i. Since the borrowing interest rate is equal to the real interest rate plus the risk
premium. The decrease in the risk premium will cause the borrowing interest rate to
decrease. This will lead to an increase in investments since the cost of borrowing has
decreased. As a result, the equilibrium level of output will also decrease. Graphically,

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the economy will start at equilibrium Point B where the LM and IS curves intersect,
the decrease in the risk premium will cause the IS curve to shift to the right (or up) to
a new equilibrium Point C with a lower borrowing interest rate and higher level of
output, but same real policy interest rate.