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As a result of the COVID-19 pandemic, the United States Central Bank (Fed) decided to bring the reference interest rate to a level of 0%
As a result of the COVID-19 pandemic, the United States Central Bank (Fed) decided to bring the reference interest rate to a level of 0%. Faced with a second wave of the pandemic and an imminent economic recession in his country, President Trump has insisted that countercyclical actions must be taken to curb the crisis. In the context of the model IS LM, indicate what would be a possible solution to such an approach.
a)The economic authorities cannot propose a solution since the economy is in the liquidity trap.
b)That the Fed carry out a bond sale accompanied by an increase in government spending.
c)That the Fed reduces the reserve ratio accompanied by an increase in government spending.
d)That the Fed makes a bond purchase accompanied by a decrease in government transfers.
Expert Solution
The three critical exogenous, i.e. external, variables in the IS-LM model are liquidity, investment, and consumption. According to the theory, liquidity is determined by the size and velocity of the money supply. The levels of investment and consumption are determined by the marginal decisions of individual actors.
The IS-LM graph examines the relationship between output, or gross domestic product (GDP), and interest rates. The entire economy is boiled down to just two markets, output and money; and their respective supply and demand characteristics push the economy towards an equilibrium point.
option d would be a possible solution according to IS-LM which will increase the liquidity and govt spending.
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