Chapter 11 - Building the IS-LM Model Flashcards
What is the implication of the fixed price level?
When the price level is fixed, shifts in the aggregate demand curve lead to changes in the equilibrium level of national income
Does not really matter if we look at nominal or real interest rate
What are the two parts of the IS-LM model and what links them?
IS curve - investment and saving, represents what is going on in the market for goods and services
LM curve - liquidity and money, represents what is happening to the supply and demand for money
As interest rate influences both investment and money demand - link between IS and LM curve
What is the goal of the IS-LM model?
Leading interpretation of Keynes theory, goal: show what determines national income for a given price level
How can we view the IS-LM model?
Two ways: either showing what causes income to change in the short run when the price level is fixed because all prices are sticky. Or as showing what causes the aggregate demand curve to shift
What is actual and planned expenditure, and why might they differ (Keynesian cross)?
Keynesian cross - building block for IS-LM model
Actual expenditure - the amount households, firms and government spend on goods and services - i.e. GDP
Planned expenditure - the amount households, firms and the government would like to spend
Difference between actual & planned investment = unplanned inventory investment
Planned expenditure = E
How do we obtain the function for planned expenditure:
E=C(Y-T ̅ )+I ̅+G ̅ ? (Keynesian cross)
Assuming closed economy, E = C + I + G
We add consumption function, C = C(Y - T)
We take investment as exogenously fixed
We assume fiscal policy fixed, i.e. fixed G and T
What is the slope of E?
According to the Keynesian cross, when is the economy in equilibrium?
Slope of E = MPC
When planned expenditure = actual expenditure, i.e. when E = Y
Based on the idea that when people’s plans have been realised, they have no reason to change what they are doing
How does the economy get to equilibrium (Keynesian cross)?
Inventories play key role in adjustment
When not in equilibrium, firms experience unplanned changes in inventories - they thus change production levels, which influences total income and expenditure - moving economy towards E = Y
What happens if Y > E (Keynesian cross)?
If Y > E, firms are selling less than they are producing
Unsold goods are added to stock of inventories, firms lay off workers and reduce production - reduction in GDP
If Y < E firms draw down inventories, hire workers and increase production
How do changes in government purchases affect the economy? Explain ΔY/ΔG
(Keynesian cross)
If G rises by ΔG, planned expenditure rises by ΔG
Equilibrium moves
The increase in income ΔY exceeds the increase in government purchases ΔG - fiscal policy has a multiplied effect on income
Government-purchases multiplier = ΔY/ΔG
Tells us how much income rises in response to a €1 increase in G
ΔY/ΔG > 1
Why does fiscal policy have a multiplied effect on income?
- According to consumption function, higher income causes higher consumption
- When an increase in G raises income, it raises C which further raises income, which then again raises C
How big is the multiplier?
Expenditure increases by ΔG, income rises by the same
Rise in income raises consumption by MPC*ΔG
This increase in C raises expenditure and income once again
This second increase in expenditure and income increases C by MPC( MPCΔG)
Process continues
ΔY/ΔG = 1/(1 - MPC)
How does a decrease in taxes affect equilibrium income?
Decrease of ΔT raises disposable income by ΔT and thus consumption increases by MPC*ΔT
For any given Y, planned expenditure is now higher - planned expenditure shifts up by MPC*ΔT
As with government spending - multiplied effect
The initial change, MPC*ΔT, is multiplied by 1/(1 - MPC)
Result: ΔY/ΔT = -MPC/ (1 - MPC) = tax multiplier
The amount income changes in response to a €1 change in taxes
Keynesian cross only a building block, investment is assumed fixed.
Investment depends on interest rate, I = I (r)
To determine how income changes when the interest rate changes, we can combine the investment function with the Keynesian cross diagram
What happens if there is an increase in interest rate?
An increase in interest rate results in decrease in quantity of investment
The reduction in planned investment in turn, shifts the planned-expenditure function downward
This causes income to fall
Hence, increase in interest lowers income
The IS curve summarises relationship between interest rate and level of income
What are the implications of the tax multiplier?
…is negative:An increase in taxes reduces consumer spending, which reduces equilibrium income.
…is greater than one(in absolute value): A change in taxes has a multiplier effect on income.
…is smaller than the govt spending multiplier:Consumers save the fraction (1-MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G.
What does the IS curve plot?
Definition: a graph of all combinations of rand Y that result in goods market equilibrium,
i.e. actual expenditure (output) = planned expenditure. Thus, the curve illustrates how the equilibrium level of income depends on the interest rate
What does the Keynesian cross show?
How income is determined for given levels of planned investment and fiscal policy. We can use the model to show how income changes when one of these exogenous variables changes
What is the equation for the IS curve?
E=C(Y-T ̅ )+I(r)+G ̅
How does fiscal policy shift the IS curve?
IS curve is drawn for a given fiscal policy, i.e. G and T fixed
When fiscal policy changes, IS curve shifts
Increase in government purchases shift the IS curve outward
Decrease in taxes also shifts the curve outward
Decrease in government purchases or increase in taxes shifts the curve inward
What is the theory of liquidity preference?
How the interest rate is determined in the short run
Interest rate adjusts to balance the supply and demand for money (the most liquid asset)
A building block for LM curve
What is the supply of M/P in the theory of liquidity preference?
The theory assumes fixed supply of real money balances (M/P)^s=M ̅/P ̅
M - exogenous policy variable chosen by central bank
P - also exogeneous variable
These assumptions implies fixed supply of M/P, and that the supply does not depend on interest rate
Hence, vertical supply curve
What is the demand for M/P in the theory of liquidity preference?
Interest rate is one determinant of how much money people choose to hold (M/P)^d=L(r)
Where L() shows that the quantity of money demanded depends on interest rate
Demand slopes downward in model
How is the interest rate determined according to the theory of liquidity preference?
Supply and demand for real money balances determine what interest rate prevails in the economy
Interest rate adjusts to equilibrate money market
How does the interest rate get to equilibrium of money supply and demand (liquidity preference theory)?
If r is above equilibrium level, supply > demand
Individuals holding the excess supply try to convert some of their non-interest-bearing money into interest-bearing bank deposits or bonds
Banks and bond issuers, who prefer to pay lower interest rates, responds to excess supply of money by lowering the interest rates they offer
When r is below equilibrium level, supply < demand, individuals try to obtain money by selling bonds or making withdrawals. To attract now scarcer funds, banks and bond issuers increase the interest rates they offer
What happens if the central bank decreases the money supply (liquidity preference theory)?
A fall in M reduces M/P as P is fixed in the model
Supply of M/P shifts to the left
Equilibrium interest rate rises, and the higher interest rate makes people satisfied to hold the smaller quantity of real money balances
Thus, decrease in money supply raises interest rate and increase in money supply lower interest rate
How do we derive the LM curve?
Put Y back in money demand equation
(M/P)^d=L(r,Y)
Greater income implies greater money demand
Quantity of real money balances demanded is negatively related to the interest rate and positively related to income
What happens to the LM curve if income increases?
Shifts money demand to the right (upwards)
Supply is unchanged, thus increase in interest rate
What happens to the LM curve if the central bank decreases the money supply?
Holding income and thus demand for real money balances constant, a decrease in the supply increases the interest rate
LM curve shifts upward
What does the LM curve plot?
The relationship between the interest rate and the level of income that arises in the market for money balances. Each point on the LM curve represents equilibrium in the money market. Drawn for a given supply of real money balances. The higher the level of income, the higher the demand for real money balances, and the higher the equilibrium interest rate - hence, LM curve slopes upward
