Suppose the central bank announces that it will pursue a monetary expansion in the current period and a monetary expansion in the future. Explain how the credibility of the central bank might influence the effectiveness of this monetary policy action and announcement of a future monetary policy action

What will be an ideal response?

If individuals do not believe the Fed, we will observe the downward shift in the LM curve causing current rates to fall and current output to rise (with no shift in the IS curve). If individuals believe that the Fed will follow through with this in the future, the LM curve will shift down causing r to fall and Y to rise. The expectation that this will continue will cause individuals to expect lower future rates and higher future output. The lower future rates will increase current C and current I. The higher future Y will do the same. So, we will also see a rightward shift in the current IS curve. This will tend to increase the current r and current Y as well. In short, we would observe a shift in the IS curve causing current Y to increase even more. So, the credibility of the Fed plays a critical role in influencing the effectiveness of monetary policy.