Question: solution Question 6 Suppose that the IS and LM relations are IS and LM relations are: IS: =C(Y-T) +1(,r+x)+G LM: r=fr Interpret the interest rate,

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Question 6 Suppose that the IS and LM relations are IS and LM relations are: IS: =C(Y-T) +1(,r+x)+G LM: r=fr Interpret the interest rate, r, as the federal funds rate adjusted for expected inflation, the real policy interest rate of the Federal Reserve. Assume that the rate at which firms can borrow is much higher than the federal funds rate. Equivalently, the risk premium, x, in the IS equation is high. Faced with a zero nominal interest rate, suppose the Fed decides to purchase securities directly to facilitate the flow of credit in the financial markets. This policy is called quantitative easing. a) If quantitative easing is successful, so that it becomes easier for financial and non- financial firms to obtain credit, what is likely to happen to the risk premium? b) In the space below, draw an IS-LM diagram and show the effect of quantitative easing. Be sure to label the axes and all the lines you draw

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