[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
The money hypothesis: A shock to the ___ curve
Asserts that the Depression was largely due to the huge fall in the ___ _____.
Evidence: M1 fell 25% during 1929โ1933.
But, two problems with this hypothesis:
___ fell even more, so M/P actually ____ slightly during 1929โ1931.
Nominal ____ _____ fell, which is the opposite of what a _____ ___ shift would cause.
Asserts that the severity of the Depression was due to huge _____:
P fell ____ during 1929โ1933.
This deflation was probably caused by the fall in M, so perhaps money played an important role after all.
LM money supply Price, rose interest rates leftward LM Deflation 25%
What are The stabilizing effects of deflation?
step by step analysis
The stabilizing effects of deflation:
โP , ^ (M/P), LM shifts right , ^Y [increase real money balances]
Pigou effect: โP, ^ (M/P ) consumersโ wealth ^ ^ C IS shifts right ^Y
What are the destabilizing effects of expected deflation?
The destabilizing effects of expected deflation: Fall in E ฯ [expected inflation] r ^ for each value of i I because I = I (r) planned expenditure and agg. demand โ income and output โ
The destabilizing effects of unexpected deflation:
_____-______ theory
Who does this transfer purchasing power from and to?
What shifts and which way? and only if what?
Who is better off from redistribution of income?
Debt-Deflation theory:
โP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less, lenders spend more
if borrowersโ propensity to spend is larger than lendersโ, then aggregate spending falls, the IS curve shifts left, and Y falls
[Redistribution of income between borrowers and lenders.
In future, with deflation, you are paying back money with a larger purchasing power, so redistribution of income]
Why another Depression is unlikely? [3]
- Policymakers (or their advisers) now know much more about macroeconomics:
- The Fed knows better than to let M fall so much, especially during a contraction.
- Fiscal policymakers know better than to raise taxes or cut spending during a contraction. - Federal deposit insurance makes widespread bank failures very unlikely.
- Automatic stabilizers make fiscal policy expansionary during an economic downturn.
How Expectations affect Consumption? [2]
What is I a function of?
What does future Productivity & r depend on?
What do we discount our cash flows using?
- Affect human wealth directly (after tax income over working life)
- Indirectly through non-human wealth (sum of financial wealth and housing wealth)
C is likely to respond less than one-for-one in current Y
C may move even if current Y does Not change
I is a func of future profits. Therefore future productivity/interest rate will impact current investment. We discount our cash flows using future r
IS curve is much steeper than the IS considered thus far:
A _____ in the current real policy rate, given unchanged expectations of the future real policy rate, does not have much effect on Private ____.
The multiplier is likely to be ____ because a change in current ____, given unchanged expectations of future income, is unlikely to have a large effect on ____.
Given expectations, a ____ in the real policy rate leads to a small increase in output. The IS Curve is steeply ____ sloping. Increases in ____ ______, or in _____ _____ _____, shift the IS curve to the right. Increases in t___, in e____ ______ _____, or in the e___ ____ ___ ____ ____ shift the IS curve to the left.
decrease, spending
small, income, spending
Decrease
Downward
government spending, expected future output
taxes, expected future taxes, expected future real policy rate
The effects of monetary policy depends on its effects on ______
Explainโฆ.
The effects of monetary policy depends on its effects on expectations:
If a monetary expansion leads to changes in expectations of future interest rates and output, then the policy effect on output may be large.
Additional shift in the IS curve.
But if expectations remain unchanged, the policy effects on output will be limited.
We can assume that expectations are _____ โ we assume rational expectations of consumers and firms (are made based of _____-_____, considerate manner)
Keynes referred to expectations as โ____ _____โ
Adaptive expectations โ they ____ their expectations over time โ r increases from 2% to 3%, you increase your expectations of future interest rates
EV??
abitrary
forward-looking
animal spirits
revise
EV- this is not how epxectations are formed- look into the future and consider a whole range of possibilites
Fall in Gov spending, IS shifts ___, giving a ___ in output โ but this is only a SR effect.
Incorporating _____ allows us to consider mid and long term effects
Gov spending falling, expected fall in ___ ___, so ____ spending expected to _____ (mid term) (reverse ____ ____)
In LR, by reducing deficit, gov doesnโt have to be stringent
Expected future taxes fall, expected future ____ rises
inwards, fall
expectations
interest rates, private, rises, crowding out
Output
Deficit Reduction, Expectations, and Output
The net effects of the three shifts in the IS curve depends on what about Policy Makers: [4, explain each one]
- Timing
Credibly backloading the deficit reduction program toward the future, with small cuts today and larger cuts in the future, is more likely to lead to an increase in output.
The programโs credibility (the perceived probability that the government will do what it has promised when the time comes to it) decreases when the government announces the need for painful cuts in spending, and then leaving them to the future. - Composition
If some government spending programs are perceived as โwasteful,โ cutting these programs today will allow the government to cut taxes in the future.
Expectations of lower future taxes and lower distortions could induce firms to invest today, thus raising output in the short run. - Initial Situation
If government debt is increasing fast, then a credible deficit reduction program is more likely to increase output in the short run, as the program announcement may well reassure the people that the government has regained control of its budget. - Monetary Policy
Even if monetary policy cannot fully offset the effect of an adverse shift in the IS curve, a decrease in the policy rate can help reduce the adverse effects of the shift on output.
So far, weโve been using the ISโLM model to analyze the ____ ____, when the price level is assumed to be ___.
However, a change in__ would shift LM and would therefore affect Y.
The ____ _____ curve captures this relationship between P and Y.
short run, fixed
P
aggregate demand
Derive the AD curve?
slide 41
Using Chain-analysis, how can The Fed can increase aggregate demand? [given price]
^ M shifts LM right
โr, ^i, ^Y at each value of P
Expansionary fiscal policy (hG and/or iT) increases agg. demand:
[Chain analysis]
โT = ^C
IS shifts right = ^Y for each value of P
SUMMARY
Derivation of IS-LM model IS-LM and effectiveness of policies Applications of IS-LM Role of expectations IS-LM and AD curve
