Question 2: The IS-LM view of the world with more complex financial markets
Consider an economy described by the following figure (notice that the only difference between this figure and the IS-LM model we have talked about in Chapter 5 lies in that we have the real rather than the nominal interest rate on the vertical axis):
a. If the nominal policy interest rate is 6%, and expected inflation rate is 4%, what is the value for the vertical intercept of the LM curve?
b. Suppose the nominal policy rate is 6%. If expected inflation decreases from 4% to 2%, what must the central bank do to the nominal policy rate to keep the LM curve from shifting?
c. If the expected inflation rate decreases from 4% to 2%, does the IS curve shift? If so, why?