IS-LM

Question 1

Define what the IS curve shows

Answer 1

The IS curve shows all those combinations of GDP and interest rate for which aggregate desired spending equals actual output

Question 2

Define what the LM curve shows

Answer 2

The LM curve shows all those combinations of GDP and interest rate for which the real demand for money equals supply

Question 3

Explain how the BofE can use monetary policy to exert pressure on GDP.

Answer 3

In order to exert upward pressure on the GDP the bank of England can increase money supply.
This will have the following effects:
a) initial excess supply of money
b) holders of this money will demand more bonds, this will raise the price of bonds and lower interest rates
c) This will induce a rise in all interest sensitive spending

This is what happened when the BofE implemented the policy of QE in 2009

Question 4

Explain why the LM curve is positively sloped

Answer 4

The LM curve is positively sloped because a rise in GDP increases the quantity of money demanded and so must be accompanied by a rise in the interest rate that decreases the quantity of money demanded by the same amount. This is in order to maintain equilibrium with total quantity demanded to total supply.

Question 5

Describe two ways in which MS will shift to the right (m0 to M1) using an LM curve

Answer 5

1) It can generate an increase in money supply.
At the original interest rate there will be an excess supply of money.
The public will seek to purchase bonds with their excess money balances.
This raises the price of bonds and lowers the interest rate.
This continues until the rate reaches r1 at which point the public is willing to hold the increased supply of money.

2) It can lower the interest rate it sets (to r1)
At the initial money supply M0 and the new interest rate r1 there is an excess demand for money m1-m0. In order to add to their money balances the public sells bonds which the Bank purchases with newly created money. This continues until the money supply has been increased to M1, leaving the market in equilibrium at the new interest rate r1.

In both cases the intreats rate falls and the money supply increases

Question 6

whats the relationship between a shift in MS and interest rates?

Answer 6

Negative. As money supply shifts to the right (increases) interest rates are likely to go down.

Question 7

What causes a shift in the IS curve?

Answer 7

A rise in autonomous spending will shift the IS curve to the right.
A fall in autonomous spending will shift the IS curve to the left.