1- Expenditure and Interest Rates Flashcards
What does the IS relationship reflect?
Expenditure and how it is affected by interest rate
What are the 3 main varieties of the LM model?
- Classic LM: based on money supply & demand
- Fixed interest
- A monetary policy rule: the central bank increases the interest rate as output increases
What does k stand for?
k is the sensitivity of money demand to changes in income
What does h stand for?
h is the sensitivity of money demand to changes in interest rates
What does b stand for?
b is the sensitivity of investment to interest rates
What does c stand for?
c is the sensitivity of consumption to output
What relationship does the LM curve tell us about?
The relationship between output and interest rates
In the classic LM model, what is money demand dependent on?
Output and the interest rate
In the classic LM model what shifts the money demand curve right and why?
A rise in income, because of the transactions motive: as income in an economy increases so do the number of transactions and money is needed for these transactions
What is the money supply curve like in the classic LM model?
As the money supply is assumed to be exogenous, fixed by the central bank, it is perfectly vertical
What does the LM curve actually show?
The LM curve shows combinations of output and the interest rate at which money demand equals money supply
How is the upwards slope of the LM curve explained in the classic LM model?
Suppose income increases; the money demand curve shifts out; with a fixed money supply this needs to be offset by a rise in interest rates
What does the intersection of IS and LM determine?
Output and the interest rate
What are the effects of an increase in the nominal money supply on the LM curve and why do they happen?
LM curve shifts out because at the current level of output, the interest rate required to maintain equilibrium in the money market is lower
What are the effects of an increase in government spending on the IS curve and why do they happen?
IS curve shifts out because output increases at any given interest rate
What happens to the IS-LM model when central banks fix interest rates?
The LM curve becomes completely horizontal
In the fixed interest rate IS-LM model how do central banks adjust the money supply to keep the interest rate constant?
When an increase in income shifts out the demand for money, the Central Bank increases the money supply to ensure that it intersects the new money demand curve at the selected interest rate
What does a monetary policy rule set out?
A monetary policy rule describes how the Central Bank sets the interest rate in order to hit its’ policy targets
What is the most prominent monetary policy rule and what does it assume?
The Taylor Rule assumes that the targets of the Central Bank are to keep inflation close to the inflation target and output close to equilibrium output
How do central banks implement the Taylor rule?
If inflation is above target, the policymaker increases the interest rate; this reduces demand and brings inflation back down towards the target. If output is above equilibrium output, the policymaker also increases the interest rate; this reduces demand and brings output down towards equilibrium.
What are 2 main reasons why policymakers would want output to be equal to equilibrium output?
- Because equilibrium output is the sustainable, average level of output
- Because the Phillips Curve implies that inflation is only stable if output equals equilibrium output
