Chapter 11 - Economic Fluctuations: Building the IS-LM Model Flashcards
What is the formula for Planned Expenditure (PE) in the Keynesian Cross Model - Goods Market in the short run?
PE = C + I + G + NX
PE: Planned Expenditure
C: C = C(Y - T): Private Consumption, T: Income Tax, an exogenous and policy variable, set by government (Suppose T = T)
Planned Investment = I = I(rbar), r: Real Interest rate
NX: Suppose economy is closed: NX = 0
Government Spending: An exogenous and policy variable, set by government,(Suppose G = G)
Draw and Label the Keynesian Cross Model (Goods Market Short Run). Start by drawing the Planned Expenditure (PE) line and its components.
The slope of PE is determined by the Marginal Propensity to Consume (MPC).
C(Y−T) rises with Y, while G and I(r) are constants in the short run.
The diagram should show an upward-sloping PE line combining the components.
In the Keynesian Cross model (Goods Market In Short Run), and how do you illustrate the equilibrium condition where Planned Expenditure equals Actual Output?
In the equilibrium Planned Expenditure = Actual Expenditure = Income = Output
What happens in the goods market when there is disequilibrium? How does unplanned inventory investment signal whether output should increase or decrease?
Disequilibrium: Occurs when Planned Expenditure (PEPEPE) is not equal to Actual Output (Y).
Unplanned Inventory Investment:
If PE<Y: Firms experience unplanned inventory accumulation (unsold goods), signaling they should decrease production.
If PE>Y: Firms experience unplanned inventory depletion, signaling they should increase production.
Equilibrium is restored when PE=Y
Draw and explain the impact of an expansionary fiscal policy on the goods market using the Keynesian Cross model.
Higher Government Spending
Planned Expenditure, PE, rises
Excess demand
Inventory levels fall
Firms raise output/income, Y
Consumption, C, rises
Draw and explain the impact of an contractionary fiscal policy on the goods market using the Keynesian Cross model.
Higher taxes
Consumption, C, falls
Planned Expenditure, PE, falls
Excess Supply
Inventory levels rise
Firms reduce output.income, Y
Suppose the interest rate r falls. What happens in the short run equilibrium in the goods market. Draw the IS curve from this shift, what is the IS curve?
Lower the real interest rate
Investment, I, rises
Planned Expenditure rises
Excess Demand
Inventory levels fall
Output Income rises
IS curve is the geometric location of all (r,Y) that brings the good market to equilibrium
Explain why the IS curve is downward sloping, write the formula for the IS curve.
PE = C(Y-T) + I(r) + G
PE = Y
IS CURVE: Y = C(Y-T) + I(r) + G
Explain how assets are used to accumulate wealth and Asset Portfolio
Assets are used to accumulate Wealth. Wealth is used to transfer consumption overtime, to smooth out th consumption path over time (maintaining a stable lifestyle), as income generally fluctuates.
If Income > Consumption -> Buy Assets -> Wealth
If Income < Consumption -> Sell Assets -> Wealth
Assets are including money, gold, bonds, shares, land, buildings, and machinery….
Short Run Assumption: Wealth is fixed
Two Types of Assets
1. Money: needed for transactions, no return
2. Bonds: not good for transactions, have return
Money vs Bonds: Liquidity vs. Return
People decide what share of their wealth should be in form of money, and what share in form of bonds (Asset Portfolio)
What is the Assumption for money market in the Short Run for Bonds? Write the formulas
Assumption: There are only one-year bonds, if someone buys them and keeps them for one year, the face value will be paid. The interest rate, i, is defined as the rate return on the one-year bonds (it can be imagined as the prime rate)
i = (Face Value / Price of Bond - 1) * 100 -> i = (1000/Pb - 1) * 100
Important: Price of bonds, Pb, and the interest rate i, have inverse relationship with each other
Explain Theory of Liquidity Preferance with Money Market in Short Run
Demand for Real Money Balances
Money, Bonds, Wealth
Money: M/P^d = L(Y+, r-)
Transaction Demand for Money: Positively related to the real income, Y
Bonds: Because we assume that in the short run wealth is fixed then demand for bonds is calculated as the residual
Speculative (portfolio) demand for money: Negatively related to the nominal interest rate, i
i= r + pie_e, suppose pie_e = 0
What happens with a higher interest rate r, with Theory of Liquidity Preferance with Money Market in Short Run. Draw the Graph
Higher opportunity cost of holding money
(M/P)^d = L(Y+, r-)
Less demand for money
More demand for bonds
Move along the curve
What happens with a higher income Y, with Theory of Liquidity Preferance with Money Market in Short Run. Draw the Graph
Higher transaction demand for money at any level of interest rate
(M/P)^d = L(Y+, r-)
Shift the whole curve
What happens with a functional shift, with Theory of Liquidity Preferance with Money Market in Short Run. Draw the Graph
Functional Shift: Technological progress in the banking and financial sector
(M/P)^d = L(Y+, r-)
Introduction of: ATM’S, Credit Cards, Internet Banking
Shift the whole curve
What is the Supply of Real Money? What is Open Market Operation? Draw the Graph
Money Supply is a policy variable set by the central Bank
Ms = M
Open Market Operation:
Expansionary Monetary Policy: When the central bank expands the money supply by buying government bonds
Contractionary Monetary Policy: When the central bank reduces the money supply by selling government bonds
