Now that you understand how the IS curve and the LM curve are derived and what makes them shift, let's start using them to make some economic predictions. In the early 1990s, the United States was going through a recession. The Federal Reserve responded by increasing the money supply.

  1. Is the IS curve or the LM curve affected by an increase in the money supply ?
  2. How do you think an increase in the money supply will affect the LM curve ?
  3. How does increasing the money supply affect output and interest rates ?
  4. Given your answer to Question 3, why do financial markets care what the Chairman of the Federal Reserve says ?
  5. If the economy is projected to slip into a recession next year and you plan to buy a house this year, should you get a fixed rate mortgage (your interest rate will not change) or a flexible rate mortgage (your interest rate will fluctuate according to changes in market interest rates) ?