Symbols: = Up = Down — = No effect ? = Uncertain Use the above symbols to fill i

Question

Symbols:         = Up             = Down        — = No effect             ? = Uncertain

Use the above symbols to fill in the table below:

b) (5 points) What if the Fed buys government securities and the government increases spending at the same time? Show your reasoning. You can use the table below:

Observations

Effect on

Ms

Md

r

I

Y

C

The Fed buys government securities

The government increases spending

Net effects

Observations

Effect on

Ms

Md

r

I

Y

C

The Fed buys government securities

The government increases spending

Net effects

Explanation / Answer

When the government buys securities -

Purchasing of government securities lead to increase in the money supply, Money demand is not impacted. Increase in money supply will lead to rightward shift of LM and thus decline in the interest rate which reduces the cost of borrowing and raises investment. This will increase income and thus consumption.

Increase in the government spending at the same time will not impact money market ( money supply and money demand) but will impact goods market and shift the IS curve rightwards. This will increase the rate of interest rate and thus decline in investment. The equilibrium level of income will increase and consumption will increase.

Net Impact - increase in Money supply

No impact on Money demand

No impact on rate of interest

Investment constant

Equilibrium level of income will increase

Consumption will increase as it is positively related to income.

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