ECON 282: Deriving the IS-LM Model Flashcards
Long Run
-Prices flexible
-output determined by factors of production and technology
-unemployment equals its natural rate
Short Run
-Prices fixed
-output determined by aggregate demand
-unemployment negatively related to output
The Keynesian cross
-A simple closed economy model in which income is determined by expenditure
Notation for Keynesian Cross
I= Planned investment
PE = C+I+G = Planned expenditure
Y = real GDP = actual expenditure
-Difference between actual and planned expenditure = unplanned inventory investment
Elements of the Keynesian Cross
Consumption function: C = C(Y-T)
Government policy variables: Gbar and Tbar
Planned investment is exogenous=I=Ibar
Planned expenditure: PE=C(Y-Tbar)+Ibar+Gbar
Equilibrium Condition: actual expenditure = planned expenditure
Y=PE
An increase in government purchases in the Keynesian cross
-At Y1, there is now an unplanned drop in inventory
-so firms increase output, and income rises toward a new equilibrium
The government purchases multiplier
The increase in income resulting from a one dollar increase in G
(change in Y)/(change in G)=1/(1-MPC)
Why is the government purchases multiplier greater than 1?
The government spends more money, which causes the economy to make more stuff, But when people earn more, they spend more (increase in C), and this cycle repeats, making the overall impact on income greater than the initial change in government purchases
An increase in Taxes
-Initially, the tax increase reduces consumption and therefore PE
-So firms reduce output ad income falls towards a new equilibrium
-At Y1 there is now an unplanned inventory buildup
The tax multiplier
-the change in income resulting from a 1 dollar increase in T
(change in Y)/(change in T) = (-MPC)/(1-MPC)
The tax multiplier is negative…
A tax increase reduces C, which reduces income (Y)
The tax multiplier is greater than 1
A change in taxes has a multiplier effect on income
-has a big impact
The tax multiplier is smaller than the government spending multiplier
-Consumers save the fraction (1-MPC) of the tax cut, so the initial boosting spending from a tax cut is smaller than from an equal increase in G
A tax cut doesn’t make people spend as much as an increase in government spending does
(when governments spend more money it goes into the economy and people make more income, and spend more
What are the effects of an increase in planned investment on the equilibrium level of income/ output
- There is an unplanned inventory drop
-Increase output and income
-New equilibrium rises
The IS Curve
-A graph of all combinations of r and Y that result in goods market equilibrium
Example: actual expenditure (Output) = planned expenditure
Why is the IS curve negatively sloped
A fall in the interest rates motivates firms to increase investment spending, which drives up total planned spending.
-To restore equilibrium in the goods market, output (aka actual expenditure, Y) must increase
Shifting the IS curve with a change in G
At any value of r, an increase in G leads to an increase in PE, and an increase in Y… so the IS curve shifts to the right
The horizontal distance of the IS shift equals:
Change in Y: (1/(1-MPC))x(Change in G)
Shifting the IS curve: change in T
-At any value of r, increase T leads to decrease in C and decrease in PE
-So the IS curve shifts to the left
The horizontal distance of the IS curve shift from change in T equals
(change in Y)=(-MPC)/(1-MPC)x (Change in T)
The theory of liquidity preference
-John Maynard Keynes
-A simple theory in which the interest rate is determined by money supply and money demand
Money Supply
The supply of real money balances is fixed: (M/P)^s=M/P (bar, bar)
Money demand
Demand for real money balances
(M/P)^2 = L(r)
How does the Bank of Canada raise the interest rate?
A fall in the money supply raises the interest rate
The LM Curve
(M/P)^d=L(r,Y)
-graph of all combinations of r and Y that equate the supply and demand for real money balances
Why the LM curve is upward sloping
-An increase in income raises money demand
-Since the supply of real balances is fixed, there is not an excess demand in the money market at the initial interest rate
The interest rate must rise to restore equilibrium in the money market
How change in M shifts the LM curve
-The BoC reduces the money supply, raising the interest rate, and shifting the LM curve upward
The short run equilibrium
-The short run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods and money markets
Y= C(Y-T)+I(r)+G
M/P= L(r,Y)
