Combining goods and money market Flashcards
What does this convey: I=I(Y, i-expected inflation)
Investment is a function of income and the real interest rate. Rise in production = rise in investment. Rise in real interest rate = higher borrowing cost = lower investment.
What does the IS curve show?
A fall in interest rate leads to a rise in equilibrium output, downward sloping curve.
How is the IS curve derived?
From the equilibrium in the goods market at a given interest rate. When interest rate rises, investment and consumption falls so demand falls causing a shift in the ZZ curve creating a new equilibrium.
What causes a shift in the IS curve?
Any factor that affects AD e.g T,G,C,I etc
What does this mean: M/P = YL
Real money supply = money demand as a function of real income and real interest rate.
How is the LM curve derived?
From the equilibrium in the money market where MD=MS. So a rise in real income which increases money demand will be followed by a rise in interest rate so that MD can be suppressed and maintained at level of MS. This justifies why the LM curve is upward sloping as with a rise in income comes a rise in interest rate.
What factors shift the LM curve?
Factors that change MD and MS, price
Why may the LM curve be horizontal?
If the CB sets a target interest rate and maintains it at this level by adjusting the money supply.
What do points on the IS and LM curve mean?
Each point represents an equilibrium point in the goods market or money market - only where they cross are both equilibriums satisfied.
How does fiscal contraction affect the IS-LM model?
Fiscal contraction causes AD to fall, shifting the IS curve downards so interest rate falls (unless the LM curve is horizontal) and output.
Why does crowding in occur with contractionary shocks with an upward sloping LM curve?
A decrease in interest rate means investment is likely to rise which leads to a rise in AD and output, of-setting such a large fall in output.
How can the government use policies to increase output whilst not changing interest rate?
Conduct fiscal and monetary expansion as fiscal expansion shifts IS curve right which leads to rise in interest rate and monetary expansion shifts LM right causing a fall in the interest rate.
Why, when the interest rate is 0 should the CB stop conducting quantitative easing? What should they do instead?
Quantitative easing wont lead to a rise in the interest rate as LM shifts right and the interest rate remains the same, there will just be a rise in the money supply - it would only lead to inflationary pressures. The IS curve needs to shift out to allow output to increase.
