ECON 282: Deriving the IS-LM Model

Question 1

Long Run

Answer 1

-Prices flexible
-output determined by factors of production and technology
-unemployment equals its natural rate

Question 2

Short Run

Answer 2

-Prices fixed
-output determined by aggregate demand
-unemployment negatively related to output

Question 3

The Keynesian cross

Answer 3

-A simple closed economy model in which income is determined by expenditure

Question 4

Notation for Keynesian Cross

Answer 4

I= Planned investment
PE = C+I+G = Planned expenditure
Y = real GDP = actual expenditure
-Difference between actual and planned expenditure = unplanned inventory investment

Question 5

Elements of the Keynesian Cross

Answer 5

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

Question 6

An increase in government purchases in the Keynesian cross

Answer 6

-At Y1, there is now an unplanned drop in inventory
-so firms increase output, and income rises toward a new equilibrium

Question 7

The government purchases multiplier

Answer 7

The increase in income resulting from a one dollar increase in G
(change in Y)/(change in G)=1/(1-MPC)

Question 8

Why is the government purchases multiplier greater than 1?

Answer 8

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

Question 9

An increase in Taxes

Answer 9

-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

Question 10

The tax multiplier

Answer 10

-the change in income resulting from a 1 dollar increase in T
(change in Y)/(change in T) = (-MPC)/(1-MPC)

Question 11

The tax multiplier is negative…

Answer 11

A tax increase reduces C, which reduces income (Y)

Question 12

The tax multiplier is greater than 1

Answer 12

A change in taxes has a multiplier effect on income
-has a big impact

Question 13

The tax multiplier is smaller than the government spending multiplier

Answer 13

-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

Question 14

What are the effects of an increase in planned investment on the equilibrium level of income/ output

Answer 14

• There is an unplanned inventory drop
  -Increase output and income
  -New equilibrium rises

Question 15

The IS Curve

Answer 15

-A graph of all combinations of r and Y that result in goods market equilibrium
Example: actual expenditure (Output) = planned expenditure

Question 16

Why is the IS curve negatively sloped

Answer 16

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

Question 17

Shifting the IS curve with a change in G

Answer 17

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

Question 18

The horizontal distance of the IS shift equals:

Answer 18

Change in Y: (1/(1-MPC))x(Change in G)

Question 19

Shifting the IS curve: change in T

Answer 19

-At any value of r, increase T leads to decrease in C and decrease in PE
-So the IS curve shifts to the left

Question 20

The horizontal distance of the IS curve shift from change in T equals

Answer 20

(change in Y)=(-MPC)/(1-MPC)x (Change in T)

Question 21

The theory of liquidity preference

Answer 21

-John Maynard Keynes
-A simple theory in which the interest rate is determined by money supply and money demand

Question 22

Money Supply

Answer 22

The supply of real money balances is fixed: (M/P)^s=M/P (bar, bar)

Question 23

Money demand

Answer 23

Demand for real money balances
(M/P)^2 = L(r)

Question 24

How does the Bank of Canada raise the interest rate?

Answer 24

A fall in the money supply raises the interest rate

Question 25

The LM Curve

Answer 25

(M/P)^d=L(r,Y)
-graph of all combinations of r and Y that equate the supply and demand for real money balances

Question 26

Why the LM curve is upward sloping

Answer 26

-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

Question 27

How change in M shifts the LM curve

Answer 27

-The BoC reduces the money supply, raising the interest rate, and shifting the LM curve upward

Question 28

The short run equilibrium

Answer 28

-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)