The “Great Moderation” since 1985 could be due either to
smaller demand stocks when compared to the period prior to 1985 or to
a better response by monetary policymakers since 1985 to the same
demand shocks that occurred prior to 1985. Evidence to determine
which of these arguments is correct may be found by examining the
behavior of the interest rate since 1985. If the Great Moderation is
due to smaller demand shocks, then less variation in real GDP has
been accompanied by less variation in the interest rate as well. On
the other hand, if the Great Moderation is due to better response by
monetary policymakers to the same demand shocks as previously, then
the decline in the variation of real GDP has been accompanied by an
increase in the variation of the interest rate. Evaluate these
arguments using the IS-LM model.
Do you have a question?
Or is your task to evaluate the arguments made using an IS/LM framework. If so, do a little research, then take a shot. I or others will be glad to critique your answer.
It a question that asks to evaluate the arguments made using an IS/LM. Please help.
To evaluate these arguments using the IS-LM model, we need to understand how the model works and how it can help us analyze the relationship between real GDP and the interest rate.
The IS-LM model is a macroeconomic framework that shows the interaction between the goods market (IS curve) and the money market (LM curve). The IS curve represents the equilibrium condition in the goods market, where aggregate demand (C + I + G + NX) equals aggregate output (Y). The LM curve represents the equilibrium condition in the money market, where the supply of money (M/P) equals the demand for money (L(r,Y)).
Let's start with the first argument: if the Great Moderation is due to smaller demand shocks. In this case, we would expect less variation in real GDP, which would be accompanied by less variation in the interest rate.
In the IS-LM model, a decrease in demand shocks would result in a more stable aggregate demand curve (IS curve), with less fluctuation in the level of output for a given interest rate. This would cause the IS curve to become flatter, indicating a lower sensitivity of output to changes in the interest rate.
On the other hand, if the second argument is correct, and the Great Moderation is due to better response by monetary policymakers to the same demand shocks, we would expect a decline in the variation of real GDP accompanied by an increase in the variation of the interest rate.
In the IS-LM model, if monetary policymakers respond more effectively to demand shocks, they would be able to stabilize the aggregate output at a lower level of interest rate or at a narrower range of interest rates. This would cause the LM curve to become steeper, indicating a higher sensitivity of the interest rate to changes in the output.
To evaluate these arguments, we would need to compare the behavior of the IS and LM curves before and after 1985. If the IS curve becomes flatter and the LM curve becomes steeper, it would support the first argument of smaller demand shocks. Conversely, if the IS curve becomes steeper and the LM curve becomes flatter, it would support the second argument of better response by monetary policymakers.
By analyzing the behavior of the interest rate since 1985, we can observe how it has varied in relation to changes in real GDP, and therefore gain insights into whether the Great Moderation is more likely due to smaller demand shocks or better response by monetary policymakers.