IS-LM model Flashcards
the investment function, equation, variables and their explanation
-I=f(Y,I)
-Y is output, as output increases, the economy is booming, more profits, more incentive to invest (positive relationship between investment and output)
-i is interest rate, higher interest rates, more expensive to borrow, disincentivises investment (there is a negative relationship between investment and interest rate
-full equation: I=b0+b1Y-b2i
-b0 is autonomous investment (replacing of capital and always some investment in the economy)
-b1Y is sensitivity of investment to output in the economy
-b2Y is sensitivity of investment to changes in interest rates
how to find equilibrium output with new investment function
-Y=Z=C0+C1Y-C1T+b0+b1Y-b2i+G
-Y-c1Y-b1Y=C0-C1T+b0-b2i+G
-Y(1-C1-b1Y)=C0-C1T+b0-b2i+G
-Y=1/(1-c1-b1)[C0-C1T+b0-b2i+G)
how to derive the IS curve (graph and explanation)
-graph: set up Keynesian cross above the lower graph. lower graph has interest rates on y and output on x. at equilibrium point there is a dotted line going through both graphs and reaches Y0
1)rise in interest rates
2)interest rates are an autonomous variable of the Z equation so the intercept will shift down and there will be a new curve called ZZ i high
3)as the new equilibrium is lower than original, demand is lower (excess supply), suppliers will supply less so will fire more/ hire less, this leads to a fall in incomes in the economy- lower consumption and investment in the economy
4)suppliers eventually adjust to a new output Y1, dotted line to bottom curve, interest rates higher on bottom curve leading to a new point
1)fall in interest rates
2) interest rates are an autonomous variable, leads to a shift i=up and new curve called ZZ i high
3) new equilibrium is higher as there is more demand (excess demand), suppliers will react in opposite way to above
4) there is a new output, Y2, output is higher and interest rates lower, leading to a line being drawn through all three points
AND BAM THERE IS THE IS CURVE (change in interest rates leads to a movement along IS curve)
effect of changing one of the other variables (not interest rates) on IS curve
-set up graph as original (Keynesian cross above and IS curve below
-rise in government spending
-same process as before
-however, because Government spending is not interest rates, interest rates remain the same and it will shit the IS curve
-there will be an upward shift in the IS curve
money demand and simplification of assets
-money can be considered as currency (coins and cash) and bank deposits
-bonds pay a positive interest rate (i)- not used for transaction purposes, assume there is one type of bond that pays interest (i)
Real money demand equation, how it is determined and relationship between money demand and variables
-M^D/P=f(PY,L(i))
-level of transaction: PY- higher output, the more we need to purchase (positive relationship between output and real money demand)
-interest rate on bonds: i- higher interest rate, more of an incentive to invest in bonds (negative relationship between real money demand and interest rates
creation of money in the economy and curve, LM equation and conclusion
-money is created when banks make loans to individuals, firms and governments
-central bank sets interest rate and supplies real money balances perfectly elastically
-provides us with simple LM return: i=i hat
-overall, demand for money depends on output and ir, supply of money adjusts to money demand
-interest rate y, real money balance x, downward sloping curve
how to derive LM curve and graph
-set up diagram on left (interest rates on y and real money balance (M/P) on x)
-set up one money supply horizontal at set interest rate
-money demand in the middle
-on the left set up LM line meeting at money supply curve, output on x and interest on Y
rise in output due to increased government spending
1) output increases, shifting money demand to the right
2) interest rate stays the same
fall in output
1) money demand shifts to the left and output decreases
2) interest rate stays the same
effect of interest rates on IS-LM-PC model
-graph: set up Kenyesian cross with IS-LM model underneath. next to that have the M/P curve on left
Keynesian cross
1) fall in interest rates shifts up y-intercept
2) process of adjusting occurs
IS-LM curve
1) as output increases, it can be shown on IS curve
2) interest rate falls so there is a movement along the IS curve
money
1) as interest rate falls so does the money supply
2) the demand for money increases
3) new money supply in line with new LM curve
