[3] IS-LM Flashcards
Three ways of expressing equilibrium in Keynesian cross
Show them algebraically
[[ THERE ARE RELEVANT COPIES OF DIGITAL CHAPTER ON LEARN. ]]
The first way: Output = aggregate demand:
๐=๐ช+๐ฐ+๐ฎ
The second way: Output = national income, hence:
๐ถ+๐+๐=๐=๐ถ+๐ผ+๐บ
๐บ+๐ป=๐ฐ+๐ฎ
The third way: Output = national product, hence:
๐ถ+๐ผ^๐+๐บ=๐=๐ถ+๐ผ+๐บ
๐ฐ^๐=๐ฐ
Graphically determine the equilibrium of AE
[use G, I, S, T graph as well]
Slide 4
What is the equilibrium for Y with taxes?
๐=๐+๐๐โ๐๐+๐ผ+๐บ
or
๐=1/(1โ๐)โ(๐โ๐๐+๐ผ+๐บ)
What is the Gov Consumption Multiplier?
What is the Tax Multiplier?
What does this imply the Balanced-Budget Multiplier equals?
government consumption: โ๐/โ๐บ=1/(1โ๐) and for taxes โ๐/โ๐=โ๐/(1โ๐)
Implication: balanced-budget multiplier
โ๐/โ๐บ+โ๐/โ๐ = 1/(1โ๐)+(โโโ ๐/(1โ๐))=1
When applying the model to the ECB, what are 2 key aspects brought to attention by Mario Draghi?
How do these 2 issues affect the model?
- Uncertainty
- Monetary Stimulus
[look up in lec capture]
Derive the IS curve [3 graphs]
slide 8
What affects the slope of the IS curve? [2]
slope of the IS curve depends on 2 factors : 1. The sensitivity (elasticity) of investment and saving to changes in the interest rate [the interest sensitivity coefficient], 2. Size of the multiplier
Derive the IS curve with Government?
slide 10
What is the savings function? and Including gov?
What is the investment function? and Including gov?
Now put this into the keynsian cross equation?
๐ผ+๐บ=๐+๐
Saving function:
๐=โ๐+(1โ๐) ๐_๐=โ๐+(1โ๐)(๐โ๐)
Investment function:
๐ผ=๐ผฬ
โ๐๐
where ๐_1>0.
๐ผฬ
โ๐๐+๐บ=โ๐+(1โ๐)(๐โ๐)+๐
Rearranging the equation we get:
๐ = 1/(1โ๐) * (๐+๐ผฬ
+๐บโ๐๐โ๐๐)
What factors shift the IS curve?
IS curve represents the goods market equilibrium.
Changes in autonomous consumer expenditure
ย Changes in planned investment spending unrelated
to the interest rate
ย Changes in government spending
ย Changes in taxes
ย Changes in net exports unrelated to the
interest rate
3 Factors affecting the demand for money:
Transaction > to carry out transactions to purchase G&S [opp cost equal to the rate of interest] When R ^, demand for money falls
- Precautionary > Higher your income, the more money you can hold as a buffer
- Speculative > Bond prices and the rate of interest [neg relationship] As r increases, the price of the bond falls (as capital gain can be made) [assumes all bonds the same] With a higher interest rate, there is higher returns on other bonds so these are more attractive
What is the Critical Rate of interest?
What are the implications for interest below the critical rate?
Critical Rate (rCi): any r below this means that consumers expect the r to rise and therefore the bond price to fall [so there losses outweigh any gain in interest] So ppl are more willing to hold their money. As r falls, the demand for money (spec) rises exponentially
What does very low r result in and why?
Very low rates of interest = liquidity trap = bc ppl are almost certain that the r will rise!
liquidity preference may become virtually absolute in the sense that almost everyone prefers holding cash rather than holding a debt which yields so low a rate of interest.
Why is the money demand curve downwards sloping?
Md downwards sloping bc neg related to r. As Y inc, Md inc bc they have a posi relationship.
What does the LM curve represent?
What is the slope of the LM curve?
LM curve represents equilibrium in the money markets (Md &Ms) for given levels of interest and National Income
The income sensitivity of demand for real money over the interest sensitivity of demand for real money.
c1/c2 = the slope of the LM curve.
What does interest elasticity of money demand mean?
interest elasticity of money demand โ means how sensitive Md is to changes in r
High interest elasticity of Md;
Md is ______ ______ so a _____ change in r required to offset the increase in demand
This brings a ______ LM schedule.
very responsive
small
flatter
What causes a movement along the LM?
What factors cause a shift in the LM?
EGs
KEY POINT: It is for the same level of income Y0. If the income changes then, causes a movement along the LM
Change in the Ms with the income held constant [outward shift of Ms causes LM to shift right and r must fall] eg : QE
Demand change results from change in anything apart from income eg: uncertainty = ^ Md, less demand for bonds
Above LM:
Below LM:
Above IS;
Below IS:
Above LM = excess supply of money, so lower r to reduce supply
Below LM = excess demand for money, so have to increase r to reduce demand
Above IS = excess supply of output (exceeding demand), so have to reduce level of output or income
Below IS = excess demand for output (higher than 45 degree line)
Equation for IS and LM?
What is the slope for each?
What does c1 and c2 represent?
๐ผ๐: ๐=1/(1โ๐) * (๐+๐ผฬ +๐บโ๐๐โ๐๐) โ ๐ ๐๐๐๐ =โ(1โ๐)/๐_1
๐ฟ๐: ๐ = ๐0/๐2 โ (๐0๐ )/๐2 + ๐1/๐2 ๐ โ ๐ ๐๐๐๐=๐1/๐2
c1: Change in Money Demand when income changes
c2: Chagne in Money Demand when interest rate changes
Express:
Spending โ๐/โ๐บ=
Tax โ๐/โ๐=
Monetary multiplier โ๐/(โ๐๐ )=
algebraically
What does monetary multiplier also effect?
โ๐/โ๐บ=1/(1โ๐+๐_1 ๐_1/๐_2 )>0
โ๐/โ๐=(โ๐)/(1โ๐+๐_1 ๐_1/๐_2 )<0
tax multiplier [also affects investment increases , so offsets the initial fall in output] (^ T, dec IS, Dec r, inc investment > offsets fall)
โ๐/(โ๐๐ ) = (๐_1/๐_2 )/(1โ๐+๐_1 ๐_1/๐_2 )=๐_1/((1โ๐)๐_2+๐_1 ๐_1 )>0
monetary multiplier [also affects investment]
The U.S. Recession of 2001
Causes [3]
Responses [3]
CAUSES: Over optimism in technology and stocks not priced at their intrinsic value. [increases in comp ownership, from luxury to necessity]
Lower r, higher availability of capital, higher vol of speculative investment. Many Tech IPOs (Yahoo!) were successful developing interest in industry
Decline in stock market
9/11
Accounting scandals within big firms
RESPONSES: Expansionary M.P
Tax cuts and emergency spending measure to rebuild NY and bail out airline industry
The Great Depression: what were the 2 Hypotheses of its causes
Spending Hypotheses
Money Hypotheses
The spending hypothesis: Shocks to the ___curve
Asserts the Depression was largely due to an exogenous ___ in the ____ for goods and servicesโa ___ shift of the _____ curve.
Evidence: ___ and ____ ___ both fell, which is what a Leftward ___ shift would cause.
Stock market crash reduced ______
Oct 1929โDec 1929: S&P 500 fell 17%
Oct 1929โDec 1933: S&P 500 fell 71%
Drop in _____
Correction after overbuilding in the 1920s.
Widespread _____ failures made it harder to obtain _____ for investment.
______ fiscal policy
Politicians ______ tax rates and _____ spending to combat increasing deficits.
The spending hypothesis: A shock to the IS curve
Fall
Demand
Leftward
IS
output interest rates IS Consumption Investment bank financing contractionary Raised, cut