Chapter 12 - Applying the IS-LM model

Question 1

How does an increase in government purchases shift the IS curve and change the short-run equilibrium?

Answer 1

Increase in government purchases of ∆G

Raises the level of income at any given interest rate by ∆G/(1-MPC) – shifts IS curve to the right by this amount
Both income and the interest rate increase

(Increase in planned expenditure, increases total income)

As economy’s demand for money depends on income – increase in income means increase in quantity demanded at every interest rate

As supply of money has not changed – increase in r

The higher interest rate in the money market influences the goods market – firms cut back on investment

Partially offsets the expansionary response to increase in G

Hence, increase in income in response to fiscal expansion is smaller in IS-LM model than in Keynesian cross (where I is fixed)

Question 2

How does a change in taxes affect the IS-LM model?

Answer 2

Same as G except that taxes affect expenditure through consumption

Decrease in T – encourages consumers to spend more, thus increase in C. According to Keynesian cross – raises the level of income at any given interest rate by ∆T*MPC/(1-MPC). IS curve shifts to the right by this amount. Increase in income and interest rate

Because consumers save (1−MPC) of the tax cut, the initial boost in spending is smaller for ∆T than for an equal ∆G so the effects on r and Y are smaller for a change in T than for an equal in G

Again, as higher interest rate depresses investment, the increase in income is smaller than in Keynesian cross

Question 3

How does the IS-LM change if there is an increase in money supply?

Answer 3

Increase in M leads to increase in M/P as P is fixed in the short run

The theory of liquidity preference – for any given level of income, and increase in M/P leads to lower interest rate – downward shift of LM curve

Lower interest rate and raises income

(When M is increased, people have more money than they want to hold at current r. deposit or buy bonds, r falls until people are willing to hold all the extra money. Lower r stimulates planned investment which increases planned expenditure, production and income)

Monetary transmission mechanism – an increase in the money supply lowers the interest rate, which stimulates investment and thereby expands demand for goods and services

Question 4

How does monetary and fiscal policy interact if there is a tax increase?

Answer 4

Three ways the central bank can respond:

(1) hold money supply constant, IS curve shifts to the left, income falls, interest rate falls (lower income reduces demand for money). recession
(2) bank wants to hold interest rate constant – thus when IS curve shifts to the left, the central bank must decrease the money supply – shifts LM curve upward. Interest rate does not fall, but income falls by a larger amount than if the central bank had held money supply constant. Deepens recession
(3) wants income to be constant – must raise money supply and shift LM curve downward enough to offset shift of IS curve. Large fall in interest rate. Change in allocation of economy’s resources, higher taxes depress consumption, but lower interest rate stimulates investment

Question 5

Suppose the government increases G.

What are 3 possible central bank responses?

Answer 5

1. hold M constant - IS curve shifts right - LM curve does not shift
2. hold r constant - IS curve shifts right - To keep r constant, the central bank increase M to shift LM curve right
3. hold Y constant -
   IS curve shifts right - To keep Y constant, the central bank reduces M to shift LM curve left

Question 6

What are shocks to the IS curve?

Answer 6

Exogenous changes in the demand for goods and services

E.g. Keynes suggest investors’ animal spirits – self-fulfilling waves of optimism/pessimism

E.g. pessimistic about the future – reduction in investment demand – at every interest rate, firms want to invest less. Reduces planned expenditure and shifts IS curve to the left – reducing income and employment

Can also arise from changes in demand for consumer goods – e.g. if consumers save less. Upward shift in consumption function, increases planned expenditure, shifts IS curve to the right and raises income

Question 7

What are shocks to the LM curve?

Answer 7

Exogenous changes in demand for money

E.g. increase in amount people want to hold, shifts LM curve upward which raises interest rate and depresses income

Question 8

What is the central bank’s policy instrument: the money supply or the interest rate?

Answer 8

Both

Central bank sets interest rate at which it is willing to lend to commercial banks on short-term basis – refinancing rate

Central bank’s bond traders conduct the open-market operations necessary to hit the target

These open-market operations change the money supply and shift the LM curve so that the equilibrium interest rate equals target interest rate

Question 9

Why do central banks choose to use an interest rate rather than money supply as the short-term monetary policy instrument?

Answer 9

Shocks to LM curve are more prevalent

When interest rates are targeted, automatically offsets LM shocks by adjusting money supply, although this policy exacerbates IS shocks

If LM shocks are the more prevalent type, then a policy targeting the interest rate leads to greater economic stability than a policy of targeting the money supply

Interest rates easier to measure than money supply

Question 10

What is the relationship between price level and national income according to the quantity theory of money?

Answer 10

For a given money supply, a higher price level implies a lower level of income

Increases in money supply shift the aggregate demand curve to the right and decreases to the left

Question 11

How can we use the IS-LM model to show why national income falls as the price level rises – i.e. why the aggregate demand curve is downward sloping?

Answer 11

For any given money supply, a higher price level reduces the supply of M/P

Lower supply of M/P shifts LM curve upward, which raises equilibrium interest and lowers equilibrium income

The aggregate demand curve plots the negative relationship between national income and the price level

Hence, the aggregate demand curve shows the set of equilibrium points that arise in the IS-LM model as we vary the price level and see what happens to income

Question 12

What causes the aggregate demand curve to shift?

Answer 12

A change in income in the IS-LM model resulting from a change in the price level represents a movement along the aggregate demand curve

A change in income in the IS-LM model for a given price level represents a shift in the aggregate demand curve

Question 13

How does an expansionary fiscal policy affect the demand curve (AD curve)?

Answer 13

Increase in aggregate demand, consumption increases

IS shifts right and Y goes up for each value of P

Question 14

What happens if the central bank increases aggregate demand (monetary policy)?

Answer 14

An increase in M makes the LM curve shift right

r decreases, I decreases and Y increases for each value of P

Question 15

How can we use the IS-LM model both in the short- and long-run?

Answer 15

Designed to explain economy in the short-run when price level is fixed, in the long-run the price level adjusts to ensure economy produces at its natural rate

If equilibrium in the short run is less than natural level, eventually the low demand will cause prices to fall, economy moves back to natural rate

Thus, the force that moves the economy from the short run to the long run is the gradual adjustment of prices.

Question 16

What is the key difference between the classical approach and the Keynesian approach?

Answer 16

Key difference from Keynesian to classical approach – Keynesian assumes price level stuck, output may deviate from natural level, classical – price level fully flexible. Price level adjusts to ensure national income is always at natural level

In other words – classical approach fixed output and allows price level to adjust, Keynesian fixed price level and allows output to adjust

Classical best describes long run, Keynesian best describes short run

Question 17

What is the liquidity trap?

Answer 17

According to the IS-LM model, expansionary monetary policy works by reducing interest rates and stimulating investment spending.

But if interest rates have already fallen almost to zero, then perhaps monetary policy is no longer effective. Nominal interest rates cannot fall below zero: rather than making a loan at a negative nominal interest rate, a person would just hold cash.

In this environment, expansionary monetary policy raises the supply of money, making the public more liquid, but because interest rates cannot fall any further, the extra liquidity might not have any effect

Aggregate demand, production and employment may be ‘trapped’ at low levels

Question 18

Counterarguments to liquidity trap

Answer 18

One response is that expansionary monetary policy might raise inflation expectations. Even if nominal interest rates cannot fall any further, higher expected inflation can lower real interest rates by making them negative, which would stimulate investment spending.

A second response is that monetary expansion would cause the currency to lose value in the market for foreign-currency exchange. This depreciation would make the nation’s goods
cheaper abroad, stimulating export demand. This second argument goes beyond the closed economy IS-LM model we have used in this chapter, but it has merit in the open-economy version of the model

A third possibility is that the central bank could conduct expansionary open-market operations in a larger variety of financial instruments than it normally does. For example, it could buy mortgages and corporate debt and thereby lower the interest rates on these kinds of loans.

Question 19

What are the exogenous variables of the IS-M model?

Answer 19

M, G and T. P is exogenous in the short run, Y is in the long run

Question 20

What are the endogenous variables in the IS-LM model?

Answer 20

R, Y is endogenous in the short run, P is in the long run