A. Short Run Flashcards
What are the three parts of describing a model?
Assumptions
Results
Robustness
What are the key variables on the demand side?
Consumption Investment Government expenditure Taxation Net exports Exchange rate Money demand Money supply
What are the key variables on the supply side?
Production function
Labour market
Technological change
What are the Keynesian cross and IS-LM models used for?
Studying output fluctuations and the effect of policy change
What do we assume about the AS curve in this topic?
We assume it is horizontal and so production adjusts automatically without price changes
What does the clasical economy assume about AS?
That the labour market is always in full employment so AS is vertical and there are no business cycles
What does the new keynesian economy assume about AS?
In the SR prices are sticky which means firms are reluctant to change prices when demand shifts. AS is non linear and upward sloping
In a classical economy what does a shift in AD cause?
It causes only a shift in price
In a keynesian economy what does a shift in AD cause?
It causes only a shift in output
Equation for production (GDP)
Y=C+I+G+X-M
Y=Co+C1(Y-T)+I+G
Y=1/(1-C1)(Co+I+G-C1T)
What simplifications do we need to make to determine z?
- all firms produce the same good
- firms are willing to supply any amount of the good at a given price and meet demand in the market
- the economy is closed to international trade
What does consumption depend on?
Disposable income
Consumption function
C=Co+C1(YD)
Autonomous spending
The demand for goods that doesnt depend on output, it is the intercept in the K cross
What is the effect of an increase in savings on GDP according to the K cross model?
The K cross model predicts if people save more at a given level of disposable income the equilibrium level of output and income decreases
What is the effect of an increase in investment in the K cross model?
GDP increases, the magnitude is dependent on the multiplier
What leads to a bigger effect on GDP, taxation or government spending?
Government spending
Does the economy respond more to a change in autonomous spending or a case where taxes are independent of income?
Economy responds more to case where taxes are independent of income
Limitations of K cross model
- static model
- prices are assumed fixed
- no role of interest rate
- investment is assumed to be exogenous
- consumption and saving depend only on current disposable income
- MPC is fixed
Which markets does the IS-LM model contain?
Goods market
Money market
Aggregate demand
What new assumptions do we need to make about variables
- investment depends on income and interest rate
- money demand is a choice between money and bonds
- money supply is exogenous, the growth rate of money supply equals zero in the medium run
How can finanical wealth be held?
As cash or bonds
What does the proportion of money and bonds you wish to hold depend on?
- your level of transactions (PY) - proportional to income
* the interest rate on bonds (i)
What affects the money supply?
Only the central bank
How does interest rate react after an increase in nominal income?
It also increases so that the money supply stays constant
How do interest rates react to an increase in the money supply?
Interest rates fall in order to induce the private sector to hold more money
How does the central bank control the money supply?
They change the money supply by buying or selling bonds in the bond market i.e Open Market Operations
What happens if the government buys bonds?
The money supply increases and so interest rate decreases
LM equation
M/P= YL(i)
What does the LM curve look like?
Interest rates on Y axis
Income on x axis
LM curve is upwards sloping
What shifts the LM curve down?
An increase in the money supply
What determines investment?
They depend on the level of sales and the interest rate
Investment function
I=I(Y,i)
How does investment behave in the short run model?
Like consumption, it doesnt add productuve capacity
What are the two reasons for why demand is sn increasing function of output?
- An increase in output lears to an increase in income and also to an increase in disposable income and therefore consumption
- An increase in output also leads to an increase in investment
Factors that shift the IS curve
- changes in autonomous consumer expenditure
- changes in gov spending
- changes in taxes
Factors that shift the LM curve
- changes in money supply
- autonomous changes in money demand
Describe changes in IS LM diagram after a loss of consumer confidence
Less consumption means less Y so IS shifts inwards.
Steps to work out new equilibrium in IS LM model
- Work out what has happened to exogneous variables Ms, G, T
- Work out how that effects Y and I
- Work out equilibrium and explain changes in other variables
What opposing effects does expansionary fiscal policy have?
Multiplier effect and crowding out
Crowding out
Occurs when expansionary fiscal policy causes interest rates to rise, thereby reducing private spending, particularly investment
What is the effect of expansionary fiscal policy on investment in the SR?
It is ambiguous
What determines whether fiscal or moentary policy is more effective?
if IS is shallow amd LM is steep then monetary policy is more effective and vice versa
When is investment sensitive to a change in interest rates?
When IS is shallow
When is money demand sensitive to a change in interest rates?
When LM is shallow
When is moentary policy ineffective?
- if the elasticity of money demand w.r.t the interest rate is infinite- liquidity trap
- if the elasticity of investment w.r.t the interest rate is zero- IS is vertical
How effective is fiscal policy in the presence if a liquidity trap?
Very effective
What is the view of keynesians on moentary and fiscal policy?
- money demand is unstable and highky elastic
- investments arent very sensitive to interest rates
- FP>MP
What is the view of monetarists on fiscal and monetary policy?
- money demand is stable and dependent on P and Y
- investments are sensitive to interest rates
- MP>FP
Limitations of IS- LM model
- effects of policies depend on slopes
- prices are assumed fixed
- consumption depends only on current disposable income
- closed economy model
