Suppose that the financial crisis causes the Fed to adopt quantitative easing. The quantitative easing reduces the term premium to 0.5 percentage points and reduces the risk premium to its pre-crisis level of 2.0 percentage points.
(a) Explain how quantitative easing would reduce the term premium and the risk premium.
(b) For interest rates between 0 and 8, with intervals of one-half of a percentage point, graph the new LM curve for the government bond rate and the new LM curve for the private bond rate, given the Fed’s quantitative easing.
(c) Use the graph of the new LM curves for the government and private bond rates, together
with the IS curve from part (a) of problem 2 to explain what the new equilibrium interest rates for the government and private bond rates are and what the new equilibrium level of income is.
(d) Discuss how your answers to part (e) of problem 1 and part (c) of this problem illustrate how monetary policy alone may not be capable of leading an economy out of as deep a downturn as the one of the Global Economic Crisis.