Applying the IS-LM Model

Question 1

Why do you want the IS-LM model?

Answer 1

• Explains the effect of Fiscal and Monetary
• Combines Keynesian Cross model and Theory of liquidity preference

Question 2

What does Fiscal Policy do to the IS curve?

Answer 2

• Increase in Government Spending shifts the IS curve outwards
• Equilibrium Point moves to a higher IR and higher Y
• Demand for money increases, r increases which reduces Investment

Question 3

What does Monetary Policy do to the LM curve?

Answer 3

• Increase in Money Supply shifts the LM curve outwards
• Equilibrium Point moves to a lower IR and higher Y

Question 4

What must be accounted for within the IS-LM model when moving to the real world?

Answer 4

• In the Model, M, G and T are exogenous
• In the Real World, Monetary Policy-Makers may adjust. M to respond to changes of Government Policy
• Can work with or against the Government

Question 5

If the Government engage in expansionary fiscal policy, what options does a central bank have?

Answer 5

1. Hold M constant
2. Hold r constant
3. Hold Y constant

Question 6

What are some shocks to the IS-LM model?

Answer 6

• IS shocks: Exogenous changes in the demand for goods and services (changes in consumer income, changes in confidence)
• LM shocks: Exogenous changes in the demand for money (changes in spending patterns)

Question 7

How does the IS-LM model link to Aggregate Demand?

Answer 7

• In the SR, there is an assumption that prices are fixed
• A change in P would shift the LM curve and would change Y
• AD measures the relationship between P and Y
• By increasing M, LM shifts right, r falls and I increases, Y increases at all P values (AD shifts right)
• By increasing G, IS shifts right, r and Y rise at all values of P (AD shifts right)

Question 8

State the gradients of the AS curves

Answer 8

• SRAS = 0 (PL = fixed)
• AS = 1
• LRAS = ∞ (PL = fully flexibly)

Question 9

What types of policy will impact Y in each period

Answer 9

• SR, AD policies can be helpful
• LR, you need to use AS policies
• If Y > Ȳ in SR, P will rise in LR
• If Y < Ȳ in SR, P will fall in LR

Question 10

What are the two theories of Depression?

Answer 10

• 1. Exogenous fall in the demand for goods and services as a result of a stock market crash and a lack of I
• This shifts IS curve inwards
• 2. Exogenous fall in MS due to P falling more than expected prices
• This stems from a Pigouvian Effect and deflationary pressure, hence LM curve shifts rightwards (r rises)

Question 11

Explain the Destabilising Effect of Expected Inflation

Answer 11

• Exp. Inf. falls, r increases for each value of I- hence I falls
• Lower AE, PE and Y