Chapter 11 - Aggregate Demand I: Building the IS-LM Model Flashcards
What is related to the IS curve (2 things)? and the LM curve (1 thing)
IS curve: (investment and savings)
- Keynesian Cross
- LF model
LM curve: (Liquidity Dm, and M money supply)
- theory of liquidity preference
In model of AD-AS, what are 3 characteristics that vary in the LR and SR?
LR: flexible prices, output determined by production factors&tech, U rate = natural rate
SR: prices sticky, output determined by AD, U negatively related to output
What is the IS-LM model and its 3 assumptions?
the basis of the AD curve, when demand determines EQM (instead of supply)
Assumptions:
1. SR
2. Price level fixed (SRAS horizontal)
3. Closed economy (no NX)
3 steps to derive IS curve
Keynesian cross: interactions b/w I&Y
Investment function: interaction b/w I and r
Combine both interactions to get IS curve
What is the IS curve, what does each point on it represent?
plots different combo of interest rate and income level
each point is a level which G&S in EQM
Define Keynesian Cross?
How national income is determined by aggregate expenditures in SR
Define AE and PE
Actual Expenditure (AE): firm/households/gov actually spend on G&S
Planned Expenditure (PE): firm/household/gov would like to spend on G&S
what is the difference b/e AE and PE?
unplanned inventory investment
Define Unplanned inventory investment (UII). What does it signal?
changes in inventory (unplanned) which signals PE DNE AE
When is Keynesian Cross in EQM
when PE = AE
must be when UII = 0
What are equations for PE? (and what variables represent)
(1) PE = C + I + G
(2) PE = a+c(Y-Tbar) + Ibar + Gbar
- planned C expenditure (C): C = a + c(Y-T) - a - autonomous consumption - c = MPC (b/w 0-1, +) - planned inventory expenditure I = Ibar (endogenous) - Planned gov expenditures: G = Gbar - assume Y = AE = GDP real
(3) PE = (a + Ibar + Gbar – cTbar) + cy
- Vertical intercept: bracket portion
- Slope: c = changePE/changeY
What do PE and AE represent (in terms of markets)?
PE = demand
AE = supply
When does PE curve rise? What factors change?
up/down shifts PE curve due to intercept factors
Vertical intercept = a + Ibar + Gvar - cTbar
TF: changes in a, I, G, T impact PE curve (not c since c=MPC = slope
What is the EQM condition for the Keynesian Cross?
How do you graph it?
PE = Y (aka. D=S, PE = PS)
Graphing: 45% line through origin (since PE = Y at all points)
Given the PE curve and EQM condition lines, what are steps to find EQM income level (Y, x-axis)
Steps:
1. Draw both lines
2. Set Y = PE
3. Iscolate for Y
EQM level income equation:
Ye = 1/(1-c) * ( a+I+G-cT)
How do you reach EQM after shocks (general)
When shocks in PE occur, they cause unplanned inventory changes (negative relationship w PE change), and can be adjusted to EQM income through changes in production ( positive relationship w PE change)
results in new EQM Y (income) level and new PE level)
What causes and result from an increase in PE
caused by: increase a, I, G or decrease T
Result:
PE>Y1 (shortage)
unplanned inventory fall
increase production
Market EQM result: (Multiplier)
increased PE (supply)
increased Y (output, income)
What causes and results from an decrease in PE
caused by:
decrease a, I, G
increase T
Result:
PE>Y1 (surplus)
unplanned inventories rise
decrease production
Market EQ result (multiplier)
decrease PE (supply)
decrease Y (output, income)
After a shock and adjusting to EQM income, how do you measure the change in income (Y)
Multiplier (depends on c = MPC = slope of Y=PE)
change Y = ( 1/(1-c) ) * changeI or changeG or change factor (I, G)
tax multiplier is different
How do changes in tax impact the PE (demand), and production
- Tax negatively impact PE (since tax negatively impact C)
- If PE falls -> UII increase –> reduce output
If PE rises –> UII falls –> increase output - After change Y, move to new EQM
what is tax multiplier? What are 3 characteristics? How can you measure tax multiplier? How do you find associated change in Y (income)
tax multiplier:
change in income from $1 change in T
Characteristics:
1. Negative: since T negative relation with Y (through C)
2. Greater than 1 (abs. value): multiplier effect (exception: MPC=0.5, multiplier
3. Tax multiplier < spending multiplier
Multiplier:
changeY/changeT = -MPC/(1-MPC)
Change in income:
changeY = -MPC/(1-MPC)*changeT
Is tax multiplier or expenditure/spending multiplier more? Why?
Tax multiplier < spending multiplier
Reason: change in spending (G, I) spending has bigger impact than changeT
inital change in autonomous spending does not get saved in G spending expansion process, but does her saved in tax change process
What is the Investment curve definition?
Definition:
- level of planned investment function of real interest rate (cost to borrow)
I = I(r)
What is the IS curve function a combination of?
What does it represent?
IS curve: combo of Investment function I(r) and the Keynesian cross
Represents: EQM in G&S market (through Y and r variables)
Y = C(Y-Tbar) + I(r) + Gbar
only change variables: Y and r
How does the IS curve make movements along the curve?
changer negative impact on I
changer negative impact PE
changer negative impact on Y
EX. r falls –> investment rise –> PE rise –> Y rise at the new lower r)
connect OG EQM with new EQM on the IS curve (two points graph a line)
What causes the IS curve to shift?
As an EX, how does increase a impact IS curve?
Shifts factors: anything that changes PE curve (I, G, C, a (which impacts C)
EX. a rise –> C rise –> PE rise –> Y rise –> IS rise (right)
What is the role of fiscal policy on the IS curve?
the IS-LM model sees how changes in T and G (fiscal policy) impact AD and Y
how does ChangeG (fiscal policy) shift the IS curve?
ChangeY = ?
- G positive impact on PE shift
- G positive impact on Y (through PE)
ChangeY = 1/(1-MPC)*changeG
How does changeT (ficsal policy) shift the IS curve?
ChangeY = ?
- T negative impact on PE shift
change PE = MPC*changeT - G negative impact on Y (through PE)
changeY = -MPC/MPS*changeT
Is the IS curve more volatile to changes in T or G
IS curve more volatile to G, less volatile to T
How does the LF model derive the IS curve?
initial point EQM:
at any Y on IS curve, the associated r determines EQM savings at S1 (vertical) in LF model,
Shock: Y changes
New point: at new Y, IS curve movement to new point and r, associated r positive relationship with I(R) to new point on I(r) curve in LF, and S1 shifts (negative relationship in r and S)
How are LF and G&S markets related in the IS model?
IS: represents EQ in G&S
LF: represents EQ in LF market
TF: LF EQM = G&S EQM
How will change in tax (without changing government spending) impact IS and LF?
changeT –> negative relationship t and gov savings –> negative relationship t and IS and LF
what is the theory of liquidity preference?
What is assumptions:
Theory that interest rate is determined through EQM of Md and Ms
demand for money has a negative relationship with r (negative slope)
price level fixed (TF: r=i, no inflation)
What is Money demand equation?
What is money supply equation?
What is the equilibrium condition, what brings theory of liquidity preference to EQM?
Money supply: (M/P)^s = Mbar/Pbar
Money demand:(M/P)^d = L(r)
Mbar/Pbar = L(r)
r adjusts to equate the supply/demand
What does LM stand for
Liquidity (demand for money)
M (money supply)
What are 3 assumptions of LM curve
- Price and Ms are fixed (TF: Ms fixed)
- Each point is EQM in the money market (combo of r and Y)
- upward sloping: Y positive
What is the equation for LM curve? What do variables represent?
Mbar/Pbar = L(r,Y)
adds Y into the Md equation
r - real interest rate (+ relation on Md)
Y - transaction motive (- relation on Md)
How do you derive the LM curve?
where Md = Ms to derive LM curve
At any Y (LM curve), find the associated Md (in the money market) at the rate associated with the Y.
use two points to derive the LM curve
why is LM upward sloping?
- Increase in income (Y) raises money demand
- Since Supply money fixed, now excess demand in money market at the initial rate (r)
- Interest rate rises to restore equilibrium in the money market
- TF: any change in Md must be restored to maintain EQM
EX. Y rise -> Md rise –> same Ms –> raise r to push Md down –> back to EQM
EX. r rise –> MD rise –> same Ms –> rise Y to push Md back –> back to EQM
What 3 variables shift the LM curve?
nominal money supply (Ms) (-)
price level (P) (+)
money demand (other than r and Y) (+)
How does changeM impact LM curve
Ms negative relation with LM curve
EX. M fall -> Ms falls -> new EQM in money market at new r –> new r and same Y (LM) shifts LM up
How does changeP impact LM curve
P positive relation with LM curve
EX. P fall -> Ms rise -> new EQM in money market -> lower r in EQM –> lower r at given Y (LM) -> LM shifts down
What causes movements along the LM curve?
changes in Y or r
Aka. axis variables
When is the SR EQM in IS-LM model
when combo or r and Y satisfies both EQM in the money market (LM) and G&S market (IS)
what are three points of the ketnesian cross?
basic model of income determination
takes fiscal policy and investment as exogenous
fiscal policy has multiplier effect on income
IS curve comes from? Shows combos of ?
IS curve comes from Keynesian cross when PE negatively depends on r
Shows combos of r and Y that equate PE and AE on G&S
what 3 points about theory of liquidity preference
basic model of interest rate determination
takes money supply and price level as exogenous
increase in Ms lowers interest rate (- relation)
LM curve comes from? shows combos of?
LM curve
comes from liquidity preference theory when Md depends positively on income
shows combinations of r and Y that equate Md and Ms
IS-LM model is?
intersection of IS and LM curves shows unique point (Y, r) that satisfies EQM in G&S and LF markets (simultaneously)
What is equation for IS curve (mathematically)? What do variables represent
assume proportional taxes
r = Abar/b - 1/(ab)*Y
derived from: Y = 1/(1-c)(1-t)*(a+Ibar + Gbar - br)
where…
a = 1/(1-c)(1-t)
Abar = a + Ibar + Gbar
b = sensitivity of I to change r
What determines the steepness (slope) of IS curve? What is slope formula?
Slope = 1/ab
b large -> more sensitive -> steeper IS
b small -> less sensitive -> flatter IS
a large –> large Exp. multiplier -> flat IS
a small-> small Exp. multiplier -> steep IS
What determines the position of IS curve
the value of Abar
Abar = a + Ibar +Gbar
all 3 have a positive relation with IS (shifts)
What is equation for LM curve (mathematically)? What do variables represent
Equation for LM Curve:
r = (k/h)Y - 1/h(Mbar/Pbar)
derived from money market EQM
Mbar/Pbar = kY - hr
where…
Mbar/Pbar - Money Supply
kY - hr - Money Demand
where k and h > 0
What determines the steepness (slope) of IS curve? What is slope formula?
Slope LM curve: slope = k/h
k large -> steep LM
k small -> flat LM
h large ->steep LM
h small -> flat LM
What determines the steepness (slope) of IS curve? What is slope formula?
Slope LM curve: slope = k/h
k large -> steep LM
k small -> flat LM
h large ->steep LM
h small -> flat LM
What determines the position of LM curve
value of Mbar and Pbar cause shifts
Mbar: positive relation with LM curve
Pbar: negative relation with LM curve
