DSE MACRO DOUBTS

[ViV]

Q1 In the IS-LM framework, an increase in the expected rate of inflation results in
a) an increase in the equilibrium value of income and an increase in the equilibrium value of real interest rate
b) a decrease in the equilibrium value of income and a decrease in the equilibrium value of real interest rate
c) an increases in the equilibrium value of income and a decrease in the equilibrium value of real interest rate
d) a decrease in the equilibrium value of income and an increase in the equilibrium value of real interest rate


Q2 An increase in the expected rate of inflation will
a) shift the LM curve up
b) shift the LM curve down
c) Leave the LM curve unchanged
d) have an ambiguous effect on the LM curve.

Please Explain....

[Granpa Simpson]

For Q1, if expected rate of inflation increases, the real rate of interest will decline and hence the investment will increase which will not shift the IS curve but will move along to a point with higher income level. so the answer should be c. Not sure anybody plz check.
for Q2) it will be c because LM curve does not depend on real interest rate, it is dependent on moninal interest rate.

[ViV]

in Q2 Nominal = real + expected inflation. So, increasing expected inflation doesn't increase Nominal interest rate...

[Granpa Simpson]

I am not sure but i think that we do not calculate nominal interest rate given a real one, rather its the other way round that real interest rate is calculated given a nominal interest rate...a real interest rate cannot exist without nominal one, however determination of nominal interest is purely market determined..and i think is independent of rate of inflation..rate of inflation plays a role only in determination of real interest rates..!!!

[Granpa Simpson]

However Vivek wats the answer to the first one..??

[The Villain]

@Viv ...IS is drawn for real int rate and LM for nominal interest ((Y,i) space).So Lm is not affected by expected inflation.

[ViV]

Yeah! I know these explanations but Vaibhav and I am confused with both these questions.. If I use any logic tht doesn't apply in both questions simultaneously and answer provided by the Amit Sir.

@Ron: your any point behind ur explanation that LM is not affected by expected infaltion rate when the space is nominal interest rate..

[Granpa Simpson]

Hey Vivek I am Subhayu, not Vaibhav..

[The Villain]

@viv
 2011 Quest does not mention  whether we're plotting on (Y,r) space or (Y,i) space and we're asked to find what happens to the LM curve.
Now, we know LM is a function of nominal int rate(i). So, will assume we're plotting on (Y,i) space. Hence, any change in expected inflation rate will have no impact on LM curve.

in 2009 quest we need to find what happens to the real interest rate. So, will plot in (Y,r) space. Now, an increase in expected inflation rate will have no impact on IS curve but will  shift the LM curve on the right. Hence, an inc in income level and a decr in real int rate.

[ViV]

I know u r Subhayu...
But Vaibhav and I hv the same doubt that's what I was telling..

[Dreyfus]

Hey viv what I was thinking....as pointed out by subhayu, when we consider only LM relation alone then we consider only nominal interest and since nominal interest is determined by the demand and supply forces in the market and furthermore when we consider real rate of interest then we account for inflation afterall real is in terms of goods. If we take these points then LM won't be effected by inflation as inflation will only affect the real rate of interest which is not determined in the market. So this makes sense for ques 2.

[Granpa Simpson]

he he..confusion all around.....i think Vaibhav is right..nywa lets take this matter to Akshay..!!!!

[ViV]

2009 question I was already clear.. but When I was working on the 2011 I had a doubt. The explanation you have given, came to my mind also but I was not sure and confused with the effect of expected inflation here. So, I think this is the only possible explanation which u hv stated above...
Let's wait for the Vaibhav's response on this..

@Subhayu: Akshay and I have already discussed these questions 2-3 days back but couln't come up on any conclusion..

[ViV]

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[Dreyfus]

But what about ques 1.... my explanation is not working there....

[Granpa Simpson]

Vaibhav i think it shud be c..wats the answer anyhow..?

[Dreyfus]

Subhayu the answer provided by Amit Sir is option d..

[Granpa Simpson]

[ashutosh]

This is what Blanchard Ch14 Q8 says.

[Akshay Jain]