5 IS-LM Model and Financial Crisis

Question 1

What does the IS-LM model tell us?

Answer 1

The short run equilibrium in the goods and money market

Question 2

What does the IS curve show us?

Answer 2

Investment saving curve. It shows the relationship between interest rates and income in goods market

Question 3

How is the IS curve derived?

Answer 3

From the Keynesian cross

Question 4

What does the liquidity money curve show us?

Answer 4

The relationship between the interest rate and income representing equilibrium in the money market

Question 5

What is true if price level in the IS-LM model?

Answer 5

In the short run the price level Is constant so only quantity and interest rates can vary to clear markets

Question 6

In the Keynesian crisis what is Y

Answer 6

The actual production or national income. Think if this as what is actually produced and what firms want to sell

Question 7

In the Keynesian cross what is C+I+G+NX?

Answer 7

Planned expenditure or spending. Think of it as what people are actually going to buy

Question 8

MPC

Answer 8

Marginal propensity to consume. The percentage of income spent on consumption

Question 9

What is true in equilibrium in Keynesian cross?

Answer 9

Actual production= planned expenditure

Question 10

Full employment output

Answer 10

The level of output at which all inputs in production are used at full capacity and all available labour hired

Question 11

Deflationary gap

Answer 11

The difference between full employment output and expenditure when expenditure is less than full employment . There is too much supply

Question 12

Inflationary gap

Answer 12

The difference between full employment output and expenditure when expenditure is great than full employment. Too much demand

Question 13

What does planned expenditure depend on?

Answer 13

The interest rate. Higher interest rate means lower consumption and investment

Question 14

What is the relationship between the interest rate and national income/ production for the goods market?

Answer 14

It is negative

Question 15

What does the money market depend on?

Answer 15

The expected level and value of transactions in the economy as well as the preference for liquid assets

Question 16

Relationship between money demand and interest rates

Answer 16

Negative relationship

Question 17

What can be assumed of money supply in the short run?

Answer 17

It is constant

Question 18

What does the LM curve show?

Answer 18

The interest rate that clears the money market for each level of income

Question 19

What is the relationship between interest rate and national income in the money market

Answer 19

Positive

Question 20

What is the equilibrium in the IS LM model?

Answer 20

The place where the interest rate and income are such that both markets are in equilibrium

Question 21

What does the AD AS model tell us?

Answer 21

The relationship between general price level and national income

Question 22

The great moderation

Answer 22

The boom of the late 80s gave way to recession in the early 90s then there was a period of reduced volatility.

Question 23

5 causes of financial crisis

Answer 23

1. Deregulation
2. Asset price rises and risk taking
3. Sub prime market
4. Securitisation
5. Systemic risk

Question 24

How did deregulation cause the financial crisis?

Answer 24

• regulations of banks abolished or relaxed in 80s and 90s
• new financial instruments with little regulation were made
• this changed the role of banks to be more risk taking

Question 25

How did asset price rises and risk taking cause the financial crisis?

Answer 25

• it became easier to get mortgages which increased demand for houses
• staff bonuses in investment side encouraged risk taking
• debt spiralled due to low interest rates and “generous” loan to value mortgages

Question 26

How did the sub prime market causes the financial crisis?

Answer 26

• this increased the risk of defaults

* it also opened up the market to a new crowd and so prices increased even more

Question 27

What is securitisation?

Answer 27

packaging mortgage backed securities into pools of debt and selling them

Question 28

How did securitisation cause the financial crisis?

Answer 28

• Credit agencies assessed collective debt very favourably, making packages attractive to investors.
• investors bought associated bonds from the bank in the form of an SPV which keeps the liability of the banks’ books
• institutions used credit default swaps as a means of insuring themselves against the risk of default. The problem is the insurer couldn’t pay out

Question 29

Systemic risk

Answer 29

•the expansion of securitisation and the credit default swaps market meant that many people were on track for the same losses since so many banks had exposure to credit default swaps

Question 30

What triggered the collapse in 2007?

Answer 30

Banks began to raise interest rates due to inflationary worries. This meant sub prime home owners began to default.

Question 31

Minsky moment

Answer 31

House prices started falling so speculators began to sell. The vicious cycle of falling asset values occurred

Question 32

Why couldn’t the banks lend?

Answer 32

With more mortgage payers defaulting on loans, banks were forced to call in debt and put SPVs back on their balance sheets. This limited their ability to spend

Question 33

How does this knock on effect occur?

Answer 33

Homeowners are worried about negative equity so reduce spending. Businesses are making less sales and unable to get loans due to tighter credit so employers are laid off and businesses shut down

Question 34

EMH

Answer 34

The belief that asset prices reflect all publicly available information about the value of an asset so all assets are fairly valued.

Question 35

Why was EMH thinking important at the time

Answer 35

It meant there was lots of deregulation because people believed the market was efficient when left to itself

Question 36

How was EMH proved to be inaccurate?

Answer 36

It didn’t account for irrational consumers and behaviours such as herd mentality and animal spirits

Question 37

What was Fama’s view on the financial crisis?

Answer 37

He believed there was too much intervention by the governments to step in and bail out banks and this is why they acted irresponsibly