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Assuming conditions of uncertainty, how would you employ monetary policy to stabilise the economy where instability originates in a) the goods market b) the money market.

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Introduction

Assuming conditions of uncertainty, how would you employ monetary policy to stabilise the economy where instability originates in a) the goods market b) the money market. Lecture notes 30/10/03 Plan Intro What is uncertainty? What is monetary policy? A) Goods market B) Money market Conclusion What is uncertainty? We do not know the position of the IS or the LM curve, we obtain different results depending on whether the instability originates in the goods market or the money market. If the instability is in the goods market we do not know the position of the IS curve, if the instability is in the money market we do not know the position of LM curve. In terms of monetary policy we have two alternatives, pursuing a Money Supply target or pursuing an interest rate target. A) Goods market instability When instability originates in the goods market we do not know the position of the IS curve. Interest rate target Money supply target When the IS curve shifts due to a rise or fall in investment due to a change in expectations, rise or fall in income/ output will cause changes in the demand for money. ...read more.

Middle

Money supply target In the diagram: Money demand falls- excess supply- people buy bonds - LM shifts right - increase income- decrease interest rate Money demand increases- excess demand- people sell bonds - LM shifts left- decrease income- increase interest rate In each case (increase and decrease money demand), the excess (money demand and money supply) will give rise to transactions in bonds, causing interest rate and income to change. Interest rate target With an interest rate target the central bank varies the money supply (by buying and selling bonds) at a chosen interest rate so that changes in money demand are met. The LM schedule is horizontal and does not shift when there is a shock of money demand, so there is a stable equilibrium with an interest rate target. Therefore there are no effects in the goods market, so that Y is maintained at its previous level. Therefore there is a constant equilibrium point of Y (shown on diagram). For example, negative shock: if money demand fell, there would be an excess money supply. ...read more.

Conclusion

In the IS-LM model, assets are split into 2 groups: one termed money and one composite, nonmoney asset termed bonds. Any factors that change the relative desirability of the 2 assets shifts the LM curve. The implication for the actual economy is that when the predominant source of uncertainty centres on shifts in asset demands (for bonds and money), the r target is superior. I don't think this bit now is that relevant for this particular question, but it's in our notes and if you don't have the notes from the last diagram you might not have this either: Normally associate: * Monetarists with money supply target and use of monetary policy passively * Keynes with interest rate target and use of fiscal policy actively Our analysis would support the monetarists as they argue money demand is stable but goods market subject to unpredictable shifts (shocks). Keynes fears goods market instability because of volatility of investment due to changing expectations under uncertainty, so Keynes should employ a money supply target. ...read more.

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