The aim of this question to understand the effects of zero lower bound on AD-AS and IS-LM diagrams.

a) Use the money demand/money supply diagram to derive the LM curve, including when the interest rate reaches 0.

b) Explain the meaning of the zero lower bound. What happens to the LM curve and output if the central bank decides to increase the money supply when the economy is at the zero lower bound?

c) Assume that the economy is at the zero lower bound. What is the slope of the AD curve? Draw this in a diagram.

d) How the economy adjust over time to the medium level of equilibrium if the economy is at the zero lower bound and initially the short run equilibrium output is lower than the natural level of output? Explain the adjustment process using an AS-AD diagram.

e) What action can the government take to bring the economy closer to the natural level of output when the economy is at the zero lower bound? Show the effect of this using the IS-LM model and the AS-AD model.

Answer rating: 100% (QA)

a Deriving the LM Curve with Zero Lower Bound Diagram Draw a graph with Money Demand on the vertical axis and Interest Rate on the horizontal axis Show a downwardsloping curve representing Money Deman... View the full answer