1. Based on the IS-LM curve, assume that 1) There are only two assets in this economy: money and bonds. 2) The demand for bonds decreases when income rises. 3) The supply of bonds is fixed at a given level.

a) How does the quantity demanded of bonds vary with the interest rate? On a graph with r on one axis and B (quantity of bonds) on the other, draw in this demand curve. What is being held constant along this curve?

b) On the same graph draw in the supply of bonds.

c) If the bond market is in equilibrium, what must be true for the money market? Explain.

d) What happens in the bond market when income, Y, rises? Show this on the diagram.

e) Now, on a graph with r on one axis and Y on the other, graph the relationship between r and Y such that the bond market is in equilibrium. Label this the LM curve. Is it positively or negatively sloped?

2. Continue to the last question.

a) Select a point to the right of the LM curve. Label this point A. Is the bond market in equilibrium at this point? Explain. Show this point on the bond market diagram. Explain.

b) Suppose now the Fed wishes to increase the supply of bonds in the economy. Carefully explain how it would do so. Does the wealth of the economy increase, decrease, or remain constant? Explain.

c) What, if anything, happens to the LM curve as a result of the Fed's actions?

3. Suppose, instead, that during the current crisis companies do not wish to borrow regardless of the interest rate. In particular, assume that if the investment is not sensitive to the interest rate.

a) Show the effect of this event on the equilibrium interest rate and income using the IS-LM diagram. Explain.

b) Now, suppose that the Central bank pursues an expansionary monetary policy. Show the effect on the diagram. Explain.