TipsQuestion textAssuming the central bank pursues real interest targeting, in a graph with the real interest rate on the vertical axis and national income on the horizontal axis, a reduction in the expected rate of inflation can be represented as:Question 2Answera.A movement along the IS curveA commercial bank purchases treasury bonds during the opening hours of the stock marketb.An upward shift of the LM curvec.A downward shift of the LM curve d.A rightward shift of the IS curve
Question
TipsQuestion textAssuming the central bank pursues real interest targeting, in a graph with the real interest rate on the vertical axis and national income on the horizontal axis, a reduction in the expected rate of inflation can be represented as:Question 2Answera.A movement along the IS curveA commercial bank purchases treasury bonds during the opening hours of the stock marketb.An upward shift of the LM curvec.A downward shift of the LM curve d.A rightward shift of the IS curve
Solution
The answer to your question is c. A downward shift of the LM curve.
Here's why:
The LM curve represents the relationship between the real interest rate and the level of income that arises from the equilibrium in the money market. When the expected rate of inflation decreases, people will want to hold more money because the cost of holding money (in terms of lost interest) decreases. This increases the demand for money, which, in turn, decreases the supply of loanable funds.
In the loanable funds market, a decrease in supply (with demand held constant) leads to an increase in the real interest rate. However, the central bank, which is targeting the real interest rate, will want to counteract this increase. It can do this by increasing the money supply, which shifts the LM curve downwards.
So, a reduction in the expected rate of inflation, assuming the central bank pursues real interest targeting, can be represented as a downward shift of the LM curve in a graph with the real interest rate on the vertical axis and national income on the horizontal axis.
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