IS-LM model Flashcards
what does investment depend on?
positively on production/sales
negatively on interest rate
why is ZZ flatter than the 45-degree line of Y=Z?
investment responds to production, the restriction of consumers only spending part of their additional income on consumption assumption may not hold.
what happens as a result of an increased interest rate
equilibrium output decreases through lower investment; money supply decreases
IS curve
downward sloping curve
gives relation between interest rate and output
changes in exogenous factors that alter demand for goods, at a given interest rate, shift the curve. e.g. G and T and consumer confidence
critiques of IS-LM model
omission of banks
oversimplification of financial markets
omission of dynamic effects
why is demand an increasing function of output?
increase in output leads to an increase in income and disposable income, leads to increase in consumption.
increase in output also leads to an increase in investment
thus ZZ is upwards sloping.
examples of dynamics
consumers are likely to take some time to adjust their consumption following a change in disposable income
firms are likely to take some time to adjust investment spending following a change in the interest rate and/or sales
firms are likely to take some time to adjust production following change in sales
TRUE OR FALSE: The IS relation is a behavioural relation, telling us how the suppliers of output respond to changes in the interest rate.
FALSE: Every point on the IS curve represents a possible goods market equilibrium, so the IS relation refers to the equilibrium condition of a goods market under an exogenously given fiscal policy.
TRUE OR FALSE: An increase in consumer confidence shifts the LM curve down and the IS curve to the right.
FALSE. An increase in consumer confidence corresponds to an increase in the value of the parameter c0 : autonomous spending increases and the IS curve moves right. However, the money market is not affected (beyond the effect on output), and the LM stays where it was (since the effect on output is reflected in a movement along the LM curve).
TRUE OR FALSE: If investment does not depend on the interest rate, the IS curve is vertical.
TRUE. The IS curve represents the relationship between the interest rate and the level of income that arises from equilibrium in the market for goods and services. That is, it describes the combinations of income and the interest rate that satisfy the equation Y = C(Y T) + I(i) + G. Note from above that, among the variables C, I, and G that determines Y, only investment(I) is a function of interest rate (i). So, if investment does not depend on the interest rate, then nothing in the IS equation depends on the interest rate; income must adjust to ensure that the quantity of goods produced, Y, equals the quantity of goods demanded, C + I + G. Thus, the IS curve is vertical at this level.
describe in words the effect of an expansionary monetary policy
The reduction in the interest rate increases output and consumption increases because output increases. Investment increases because output increases and the interest rate decreases
What mix of monetary and fiscal policy is needed to meet the following objectives?
a. Increase Y while keeping i constant. Would investment (I) change?
The central bank keeps the interest rate constant. Fiscal policy is expansionary as either G is increased or T is decreased. Investment will increase as output rises.
What mix of monetary and fiscal policy is needed to meet the following objectives?
b. Decrease a fiscal deficit while keeping Y constant. Why must i¯also change?
The central bank will cut interest rates as the fiscal authorities either reduces G or raises T (or both).
