Closed Economy: Extended IS-LM model (topic 4+5)

Question 1

What is Y = Z?

Answer 1

The IS relation/equilibrium in the goods market.

Question 2

How is output determined in the goods market?

Answer 2

Y = 1 / 1 - c1 * (c0 + I + G - c1 * T)

Question 3

Explain what happens in the goods market when there’s an increase in income.

Answer 3

C will increase -> Y increases.
I will increase -> Y increases.

Movement to the right along the ZZ (demand) line.

Movement to the right along the IS curve.

Question 4

What can make the IS curve shift?

Answer 4

Changes in G or T.
Increase in G or decrease in T = lower output –> IS shifts left.

Decrease in G or increase in T = higher output –> shifts right.
increase in c0 will also move the curve right.

Question 5

What is the determinant M?

Answer 5

Nominal money stock (controlled by CB).

Question 6

What is €Y?

Answer 6

nominal income.

Question 7

what happens if €Y increases?

Answer 7

Demand for money increases.

Question 8

What is the relation between money, nominal income and the interest rate?

Answer 8

M = €YL (i)

Question 9

Write the relation between real money (in terms of goods), real income and the interest rate.

Answer 9

M / P = YL(i)

Question 10

What does the relation M / P = YL(i) show?

Answer 10

the relation between real money, real income and the interest rate/LM.
nominal / price level = real.

Left side: money supply
Right side: money demand (depends on real income and interest rate)

For a given supply of money an increase in income will lead to increase in interest rate.
(real income increases > Md increases > interest rate must increase so that Md remains = Ms)

Question 11

Explain the IS-LM model graphically.

Answer 11

Production or income – is measured on the horizontal axis.

The interest rate is measured on the vertical axis.

Any point on the downward sloping IS curve corresponds to equilibrium in the goods market.

Any point on the horizontal LM curve corresponds to equilibrium in financial markets.

Only at point A are both equilibrium conditions satisfied.

That means point A, with the associated level of output Y and interest rate i, is the overall equilibrium – the point at which there is equilibrium in both the goods market and the financial markets.

Question 12

What are the 3 steps to remember when being asked about changes about effects of policies?

Answer 12

Does it shift the IS curve and/or the LM curve and, if so, how?

What does this do to equilibrium output and the equilibrium interest rate?

Describe the effects in words.

Question 13

What does the central bank do when implementing an expansionary monetary policy and what are the effects?

Answer 13

Expansionary open market operation = the central bank increases the money supply.

Central bank buys bonds and pays for them by creating money.

when the central bank buys bonds, the demand for bonds go up (and increases their price).

The interest rate on bonds goes down.

Question 14

What does the central bank do when implementing an contractionary monetary policy and what are the effects?

Answer 14

Contractionary open market operation = the central bank decreases money supply.

Central bank sells bonds and the money received in exchange is removed from the circulation of money.

Prices for bonds are decreased.

Interest rate for bonds goes up.

Question 15

What is a policy mix?

Answer 15

Using both fiscal and monetary policy.

Question 16

What is the difference between nominal and real interest rate?

Answer 16

Nominal interest rate = interest rates expressed in a national currency (DKK, euros, dollars, etc.). The nominal interest rate is often the one that is printed in newspapers and the rate that the central bank sets.

The real interest rate = expressed in terms of (a basket) goods. (r = i - π^e)

Must adjust the nominal interest rate to consider expected inflation.

Example: Assuming the only good in the market is bread.
The 1-year nominal interest rate is denoted (in terms of the national currency, euros): i_t.
If you borrow €1 this year, you will then have to repay (1+i_t) euros next year.

What you want to know is: if you borrow enough to eat an additional pound of bread this year, how much will you have to pay back in terms of bread/goods a year from now?

Question 17

What is the ex-ante and ex-post real interest rates?

Answer 17

If expected inflation differs from the actual inflation:

The real interest rate (before corrections) is the ex-ante (‘before the fact’) interest rate (i - π^e)

The realized real interest rate, also called the ex-post (‘after the fact’ where the actual inflation is known): (i-π)

Question 18

What is the relation between nominal and real interest rate?

Answer 18

r = i - expected inflation
The real interest rate is (approximately) equal to the nominal interest rate minus expected inflation.

This means when inflation = 0, the real and nominal interest rates are equal.

Because expected inflation is mostly positive, the real interest rate is typically lower than the nominal interest rate.

For a given nominal interest rate: the higher the expected rate of inflation > the lower the real interest rate.

Question 19

If the desired real interest rate (r) = 4%, the expected inflation is 2%.
How should the CB set the nominal interest rate (i)?

Answer 19

r = i - expected inflation.

6% - 2% = 4%.

Question 20

If the nominal interest rate is 0% and expected inflation = 2%, what is the real interest rate? and can the nominal interest rate be lower than 0%?

Answer 20

r = 0% - 2% = -2%

Zero lower bound makes it impossible to have a negative nominal interest rate.

Question 21

What determinants makes bonds differ from each other?

Answer 21

Maturity i.e., the length of time the promise a payback.

Risk (i.e., some are nearly riskless where others are not).

Question 22

Why can’t private people not borrow at the same rate as the government?

Answer 22

This is due to the possibility that people might not be able to repay (and the same for firms that issue bonds, some issue a small risk and others more).

Question 23

What is the risk premium?

Answer 23

Risk premium is the compensation for the risk.

The higher the probability (p) for no payback is, the higher the interest rate will investors ask for.

Denoted, x

i, nominal interest rate on a riskless bond.

i+x, the nominal interest rate on a risky bond.

Question 24

Explain the term: risk aversion.

Answer 24

Risk aversion = if expected return on the risky bond is the same as on a riskless bond, the risk itself it will make bond holders reluctant to hold the risky bond (they will ask for a higher risk premium to compensate) >
x will be higher (how much higher depends on the bond holders risk aversion).

More risk averse = risk premium goes up (even if probability of default has not changed).

Question 25

What does a bank’s leverage ratio show?

Answer 25

Leverage ratio of a bank = the ratio of assets to capital

Higher leverage ratio implies a higher expected profit rate, but at the same time a higher risk of bankruptcy (higher risk that the value of assets becomes less than the value of liabilities > implying a higher risk of insolvency.

Lower leverage => lower profits.

Question 26

A bank’s balance sheet:
Assets = 100; Liabilities = 80; capital = (100 - 80) = 20; leverage ratio = (100/20) = 5.

Explain what would happen if assets decreased to 90.

Answer 26

if assets decreased to 90 in value instead of 100 (e.g., because of bad loans), the capital of the bank would be 10 (90-80 = 10). The leverage ratio would increase to 9 (90/10 = 9). The bank would still be solvent but is more at risk.

The bank will maybe want to increase capital by asking investors to provide funds.

Question 27

what does pi^e reflect?

Answer 27

reflects the fact that spending decisions depend on (all other things equal) on the real interest rate (r=i-π^e)

Question 28

What does the real borrowing rate depend on?

Answer 28

The real borrowing rate (the rate that consumers and firms can borrow) – depends on policy rate (r) and risk premium (x).

Question 29

What is the difference between i = i-bar and r = r-bar? and what are these relations showing?

Answer 29

i = nominal policy rate 
r = real policy rate 

The LM relation.

Question 30

What happens if investors become more risk averse or a financial institution has gone bankrupt, and investors are worried about other institutions health?

Answer 30

x increases -> the IS curve shifts left.

At the same policy rate -> r+x increase -> decrease in demand and output.