F Explain the IS LM curves and how they combine to gen the agg. D curve

Question 1

Understand the factors that determine each of the components of GDP to derive the AGG.D curves

Answer 1

Consumption: Consumption is a function of disposable income. +PDI or -T will +C and +S. Additional income;marginal propensity to consume;MPC and MPS; Marginal propensity to save must = 100

Investment: Investment is a function of expected profitability and the cost of financing. Expected profitability depends on the overall level of economic output. Financing costs are reflected in real interest rates, which are approximated by nominal interest rates minus the expected inflation rate.

Government Purchases: T, therefore fiscal balance is a function of econ output

Net Exports: A function of domestic disposable incomes(which affect exports), and relative prices of goods in foreign and domestic markets.

Question 2

IS curve (inverse relationship between real income and interest rates)(IS curve plots the combos of income and real interest rates for which agg. Y and income equal planned expenditures)

Answer 2

(G-T)+(X-M) is a decreasing function of aggregate income (-slope)
+Agg. I, -(G-T); Fiscal deficit, -(X-M); trade deficit

Agg.I to (G-T);fiscal deficit, and (X-M); trade deficit = Inverse relationship.

Agg. I and (S-I), +relationship

Intersection: Level of Y Agg.I that satisfies the two equations given a particular real %

Change: -%>-Financing Costs>+Investment>(S-I) no change because +I must be accompanied by +S which results from +Inc
-%, +real Agg. Inc

+%’s will -real Agg. Inc

Income and expenditure remain in equilibrium due to the inverse relationship between Real % rate and income because I and Savings are the primary variables that adjust to maintain the balance between expenditure and income.

Question 3

LM Curve (Combos of GDP or real inc. and real interest rates that keep the Qreal money demanded = to Qreal money supplied)
In equilibrium LM curve is +income and Real R for a given level of the real MS

Answer 3

Derive the LM curve by examining the relationships between supply and demand in the financial markets

Demand for money is inversely related to the real interest rate: higher interest rate, people are less willing to hold cash that do not earn interest (more interest bearing securities, less cash)

Demand for money is positively related to real income; an inc. in Dmoney from an inc. in Inc must be offset by a -Dm by an +% rates

Question 4

Agg. D curve

Answer 4

Relationship between r.Inc;Quantity of Real Y demanded, and the Plevel

+Plevel will -real money supply (M/P)
-Plevel will +(M/P)

P level and M/P have inverse relationship which indicates a downward sloping relationship because the higher price levels (ceteris paribus MS) reduce real wealth, +real interest rates, and make domestically produced goods more expensive compared to goods produced abroad, all of which reduce the Q of domestic output demanded.