IS/LM model Flashcards
What does IS/LM stand for?
Investment Saving – Liquidity Preference Money Supply
What is the IS/LM model used for?
It shows how the economy responds to fiscal and monetary policy in the very short run (that is, when prices are fixed).
What are the two large markets that make up the economy?
Goods market: Where all goods and services are traded.
Money market: Where savers (people with spare money) meet borrowers (people who need money).
At any point in time these two markets should be in equilibrium: that is, the quantity of goods and services people want to buy should equal the quantity available to be sold; and the amount that people want to borrow should equal the amount that people want to save
What curve is used to represent equilibrium in the goods market?
Equilibrium in the goods market is represented by the IS curve.
When the interest rate is lower what does the goods market equilibrium require of output?
When the interest rate (r) is lower, goods market equilibrium requires output (Y) to be higher. This is because a lower interest rate stimulates consumption and investment demand, which are both components of output.
What curve is used to represent equilibrium in the money market?
Equilibrium in the money market is represented by the LM curve.
When output is higher, what does the money market equilibrium require of the interest rate?
When output (Y) is higher, money market equilibrium requires the interest rate (r) to be higher. This is because a higher level of output means that people are richer, which increases the demand for money, which in turn increases the interest rate, which is the ‘price of money’.
Graphically depict the goods and money market together
Notice that at interest rate r* and output Y*, the goods market and the money market are in equilibrium.
How does expansionary/contractionary fiscal policy influence the IS curve?
Expansionary fiscal policy (increasing government expenditure or reducing taxes) shifts the IS curve to the right, which increases output and the interest rate.
Contractionary fiscal policy (reducing government expenditure or increasing taxes) shifts the IS curve to the left, which reduces output and the interest rate.
How does expansionary/contractionary monetary policy influence the LM curve?
Similarly, expansionary monetary policy (increasing the money supply) shifts the LM curve to the right, increasing output and reducing the interest rate.
Contractionary monetary policy (reducing the money supply) shifts the LM curve to the left, reducing output and increasing the interest rate.
Ricardian equivalence
The basic proposition is that people’s behaviour is not substantially affected by a temporary increase in government spending or decrease in taxation, because people are forward-looking and they are aware that eventually the government must eventually pay for either of those policies by raising taxes.
Say the government suddenly paid everyone $1000. The theory holds that people would just save most of this because they know the government will eventually ask for it back in higher taxes to pay for it.
It is a theory that is quite controversial because it assumes that agents are not credit constrained (that is they can always borrow more money), are infinitely forward-looking and that an economy cannot suffer from inadequate aggregate demand
