Chapter 9: ISLM/AD-AS Model

Question 1

State an equation that algebraically represents FE

Answer 1

FE= Y bar= AF(K,N bar), fixed output, fixed labor

Question 2

Is the FE line in the ISLM Model vertical horizontal or curved?

Answer 2

Vertical to represent unchanged output despite changes in the real interest rate (since output is fixed at full employment). At FE, output equals its full employment level, irrespective of real interest rates.

Question 3

Name 3 factors that affect the FE line

Answer 3

1. Beneficial supply shock
   The FE level of output increases for both reasons.
2. An increase in labor supply
3. Increase in the capital stock

Question 4

How does a beneficial supply shock affect the FE line?

Answer 4

A beneficial supply shock shifts the FE line to the right since the FE output level increases due to higher demand for labor and equilibrium employment (due to an increase in MPN) as well as an increase in the value of A (productivity increase), corresponding to more output despite the same levels of capital and labor.

Question 5

How does an increase in the labor supply affect the FE line?

Answer 5

An increase in the labor supply increases FE (equivalent to an increase in N bar, or equilibrium employment), thus increasing Y as a result.

Question 6

How does an increase in the capital stock affect the FE line?

Answer 6

Causes a rightward shift in the FE line since labor is now more productive, thus causing labor demand to increase as a result of higher MPN and also raising equilibrium employment (rightward shift of labor demand curve corresponding to a greater labor supply). More capital also means more output can now be produced at every amount of labor.

Question 7

How is the IS curve related to the goods market?

Answer 7

Every point on the IS curve represents an equilibrium in the goods market. (at which Sd=Id)

Question 8

Why does the IS curve slope downwards?

Answer 8

Because for every corresponding rise in national output, savings increases, which causes the real interest rate to decrease. Conversely, for every rise in the real interest rate, investment and consumption decrease, thus causing aggregate demand to decrease and hence output to also decrease (for demand to equal supply again in equilibrium)

Question 9

Why does the interest rate increase when savings decreases?

Answer 9

When the savings curve shifts to the left, at the old equilibrium interest rate, investment exceeds savings. Therefore, due to the excess demand for investment, investors start to offer higher rates of return to capture funds from savers, thus causing savings to slowly increase, and demand for investment to slowly decrease until investment=savings once more at the new equilibrium interest rate.

Question 10

List the factors that shift the IS Curve

Answer 10

1. Expected Future Output
2. Wealth
3. Government purchases
4. Taxes
5. Expected future marginal product of capital
6. Effective tax rate on capital

Question 11

How does an increase in expected future output affect the IS Curve?

Answer 11

Causes desired savings to fall and desired consumption to increase (equivalent to an expected increase in future income), thus raising the real interest rate and causing the IS curve to shift to the right.

Question 12

How does an increase in wealth affect the IS Curve?

Answer 12

Causes desired savings to fall (which is set in the present: REMEMBER), and desired consumption to increase, thus causing the real interest rate to increase and output to also increase. IS Curve shifts to the right

Question 13

How does an increase in government purchases affect the IS Curve?

Answer 13

Causes national savings to decrease (since PS=T-GS), raising the interest rate. Output also increases. IS Curve shifts to the right

Question 14

How does an increase in taxes affect the IS Curve?

Answer 14

No change if Ricardian equivalence since consumers anticipate a future decrease in taxes. Causes the IS Curve to shift to the left if consumers don’t take into account the future cut and reduce consumption, increasing desired national savings and lowering the real interest rate that clears the goods market.

Question 15

An increase in expected MPK?

Answer 15

Desired investment increases, raising the real interest rate

Question 16

An increase in the effective tax rate on capital?

Answer 16

Desired investment decreases (cost of capital increases), thus lowering the real interest rate

Question 17

How is the LM Curve related to the Asset Market?

Answer 17

Every point on the LM Curve represents an equilibrium in the asset market

Question 18

What is the key relationship behind the derivation of the LM curve?`

Answer 18

The relationship between the price of nonmonetary assets and the nominal interest rate (given fixed expected inflation, real interest rate). Used to explain monetary demand and how changes in Md also also change the real interest rate.

Question 19

What causes a shift in the LM Curve?

Answer 19

A change in real money balances either stemming from a change in price level or nominal money supply (any exogenous change, one not arising from a change in real interest rates or output)

Question 20

What causes a movement along the LM Curve?

Answer 20

An increase (or decrease) in real money demand caused by an increase in income (hence the increase in both real interest rate and output). The increase in real interest rate is caused by a selloff in nonmonetary assets, which increase yields (due to the inverse relationship)

Question 21

How does an increase in income cause an upward movement along the LM curve?

Answer 21

Increase in income causes an increase in real money demand. To satisfy their excess demand for money, people will begin to sell off nonmonetary assets, causing a hike in real interest rates. However, as the real interest gradually increases, people will begin to decrease their demand for money due to the relative attractiveness of returns on nonmonetary assets. Thus eventually, real money demand decreases back to its original level, whereas the real interest rate attains an equilibrium at a higher rate.

Question 22

List the factors that shift the LM Curve

Answer 22

1. An increase in the nominal money supply
2. An increase in the price level
3. An increase in expected inflation
4. An increase in the nominal interest rate on money
5. For constant output, any increase in real money demand

Question 23

How does an increase in the nominal money supply shift the LM Curve?

Answer 23

Increase in nominal money supply increases real money balances, thus decreasing the real interest rate and also increasing the demand for money. Thus, the real interest rate is lower at every level of output. (note that output does not change, and is exogenously determined) LM Curve shifts to the right.

Question 24

How does an increase in the price level shift the LM Curve?

Answer 24

Decreases real money balances, which increases the real interest rate. Thus, at every level of output, the real interest rate is higher. Real money demand also decreases as a result of the increase in r. LM Curve shifts upwards.

Question 25

How does an increase in expected inflation shift the LM Curve?

Answer 25

Causes the LM Curve to shift to the right, since an increase in expected inflation causes real money demand to decrease and thus lowers the real interest rate. (change in real money demand, no change in output so causes shift)

Question 26

How does an increase in the nominal interest rate on money shift the LM Curve?

Answer 26

Causes real money demand to increase, thus increasing real interest rates and shifting the LM Curve to the left.

Question 27

How does a change in real money demand affect the LM Curve?

Answer 27

A change in real money demand as a result of a change in any other variable besides output and the real interest rate will cause a shift in the LM Curve. A change in real money demand as a result of a change in the real interest or in output will cause a movement along the LM Curve.

Question 28

General Equilibrium point?

Answer 28

Point at which the FE line, IS curve, and LM curve intersect.

Question 29

Effects of a TEMPORARY adverse of a supply shock on the GE point?

Answer 29

Consider the effect of a decrease in A on the FE line, LM and IS Curve.
How does a decrease in A affect FE?
Causes a decrease in output at any given amount of capital and labor (corresponding to a decrease in FE output) and a further decrease in output as a result of a fall in demand for labor (and thus equilibrium employment). Overall, a fall in A causes the FE line to shift to the left.
How does a decrease in A affect the IS Curve?
No shift in the IS Curve, movement along the curve to reflect to decrease in income.
The LM Curve shifts to the left due an increase in the price level, which causes a decrease in real money balances and an increase in real interest rates.

Question 30

Assumptions of the ISLM model?

Answer 30

real interest rates=nominal interest rates due to 0 inflation in the short run.

Question 31

Why does an increase in nominal money supply lead to an increase in the price level?

Answer 31

After the increase in nominal money supply, holders of wealth will realise that they are holding more money than they desire, and thus will attempt to dispose of this excess balance via purchases of nonmonetary assets. However, as demand for nonmonetary assets increases, the real interest rate decreases, stimulating consumption and investment. Due to the now excesses in C and I, firms will start charging higher prices to temporarily produce beyond their profit maximizing levels of output. Thus, this causes the price level to increase, which also causes real money balances to shift back to the left, thereby also shifting the LM Curve back to the left. At this “new” equilibrium, both nominal money supply and price level are higher, but output remains unchanged.

Question 32

What does an increase in the money supply actually mean?

Answer 32

An increase in the trend rate of growth (refers to not the absolute amount, but the growth rate). Usually, the price level and money supply are continuously growing at similar rates, although these two rates may sometimes fall out of sync.

Question 33

Core disagreement between the neoclassicists and the keynesians regarding price adjustments?

Answer 33

Keynesians - prices adjust slowly and are sticky in the short run. Thus, due to the stickiness of wages, the labor market is rarely in equilibrium and that output is determined by the level of AD.
Neoclassicists - consumers and producers adjust relatively quickly and efficiency; prices, therefore, are flexible and adjust quickly as well. The economy self corrects.

Question 34

What is money neutrality?

Answer 34

That changes in the nominal money stock only affect the price level, and not real variables in an economy. However, according to the Keynesians, because of the economy’s sluggishness in adjusting back to equilibrium, money neutrality does not hold in the short run but only in the long run.
Classicists assume money neutrality in the SR and LR
Keynesians assume money neutrality only in the LR

Question 35

Define the terms partial equilibrium, primary movements and secondary movements, neutral, and non-neutral

Answer 35

Equilibrium when IS intersects LM but do not intersect the FE curve together.
Primary movements: changes in the IS, LM to reflect the short run partial equilibrium.
Secondary movements: changes to reflect a move back to the GE
Neutral: that changes in nominal variables, namely money, do not affect real variables.
Non-neutral: Contrary to the above. Changes in money supply are non-neutral in the short run, meaning real variables are affected.

Question 36

What is unique about the IS-LM Model with regards to price level?

Answer 36

It is fixed in the SR, and even when it is variable it only shifts the LM Curve.

Question 37

What does the AD curve reflect?

Answer 37

Reflects the relationship between price level and output with regards to aggregate demand. Therefore, reflects shifts in the LM curve as a result of changes in price level or money supply.

Question 38

What does the AS curve reflect?

Answer 38

Relationship between price level and output from the producer perspective. In the SR, AS is completely horizontal due to the stickiness of prices, and that only output is variable in the SR. In the LR, on the other hand, AS is completely vertical to reflect the possibility for price changes but the static nature of output, which is assumed to be at full employment level and therefore is unrelated to cyclical demand.

Question 39

Define the equilibrium point in the AD/AS model

Answer 39

Intersection between LRAS, SRAS and AD.

Question 40

How is money neutrality demonstrated in the AD AS model?

Answer 40

Shift in AD curve complemented by a shift in the SRAS curve upwards to reflect higher prices in the LR. At the new equilibrium, output remains unchanged, but price level has increased.

Intuition: Increase in money supply increases AD, which increases output but also gradually a price increase. A price increase decreases real money balances and thus causes the LM Curve to shift back. (REMEMBER, the ISLM only reflects changes in the real interest rate and output)

Question 41

Another term for money neutrality?

Answer 41

Money is a veil