The IS/LM framework that we′ve used to analyze monetary policy only looks at the effect of monetary policy on current economic activity. However, people know that monetary policy of the year 2003 is likely to affect interest rates and output for years to come. To account for this fact, we alter the IS/LM framework, as shown in these equations:

The only differences are in the equation for the IS curve. Now, equilibrium in the goods market is represented by the equality of output with the sum of private spending, A (including the factors that affect private spending), and government spending, G. And private spending responds positively to expected future output, Y′^e, and negatively to expected future interest rates, r′^e. The new IS and LM curves are shown in the figure and look much like the IS/LM curves already familiar to you. The only differences are: the IS curve is much steeper and the IS curve shifts in response to changes in expected output and interest rates.

1. How does a monetary expansion shift the LM curve ?
2. How does a monetary expansion affect output and the interest rate (without taking into account the effect of the interest rate on the future, i.e., without shifting the IS curve) ?
3. But, monetary policy does affect the future. How do you think a monetary expansion will affect future interest rates and output ?
4. Given your answer to question 3, how does a monetary expansion shift the IS curve ?
5. Taking account of both shifting curves, what is the effect of a monetary expansion on output and the interest rate ?