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Economics > IS-LM Model > Flashcards

IS-LM Model Flashcards

1
Q

Define IS-LM

A

Explains how Fiscal + Monetary Policy affects Output + Interest Rates

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2
Q

Consumption = Disposable Income Function

A

C = C(Y-T)

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3
Q

IS Curve Assumption

A

Investment depends NEGATIVELY on Interest Rates- Increased IR –> Decreased Investment
-Due to Opportunity Cost

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4
Q

AD Keynesian Cross Function

A

AD = C(Y-T) + I(r) + G,

—G + T are Exogenous

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5
Q

Define the IS Curve

A

Schedule of all combinations of r + Y that result in Goods market Equilibrium

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6
Q

What is the Keynesian Cross Function

A

Y = A + c(Y-T) + Io - br + G

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7
Q

Derive the IS Curve from

Y = A + c(Y-T) + Io - br + G

A

r= 1/b [A + Io + G - (1-c)Y - cT]

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8
Q

If r Decreases, what happens to Y?

A

Decreased r –> Increased I - due to lower cost of borrowing

–> Increased AD –> Increased Y

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9
Q

What does the slope of the IS Curve mean?

A

Sensitivity of Y to IR

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10
Q

Define the LM Curve

A

Schedule that gives all combinations of Y and r that insure Equilibrium in Money Market

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11
Q

If Y increases, what happens to r?

A

Increase Y –> Increased Money Demand [L(Y, r)] –> Increased r

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12
Q

What does L(Y, r) show?

A

Liquidity Preference

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13
Q

If Liquidity Preference increases, what happens to Y?

A

Increased L.P –> Increased r –> Increased Y

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14
Q

What does a Higher IR + Income Level cause?

A

Higher Liquidity Preference

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15
Q

What does Liquidity Preference represent?

A

Demand for Money

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16
Q

What is Money Demand sensitive to?

A

Output, Y

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17
Q

What is Liquidity Preference Theory?

A

Implies a POSITIVE RELATIONSHIP between Output + IR

18
Q

How does higher Income affect Money Demand?

A

Increased Income –> Increased Money Demand

19
Q

If Money Supply is Fixed, what does Increased Income lead to?

A

Increased Income –> Increased Money Demand –> Increased IR

20
Q

What is the Money Demand Function?

A

(M/P)d = kY - hr

21
Q

Derive LM Curve from

(M/P)d = kY - hr

A

r = 1/h [kY - (M/P)]

22
Q

When the IS = LM, what is in Equilibrium?

A

Money Market = Goods Market

23
Q

If you Equate the IS + LM Curves, IS = LM, what can you find?

A

Equilibrium IR + Output, r* & Y*

24
Q

What can the IS-LM Model be used to analyse?

A

Can be used to analyse the Effects of Fiscal + Monetary Policy

25
Q

What happens if G Increases?

A

IS Curve Shifts to the Right by (dG / 1-MPC)

26
Q

What does Increased G cause?

A

Crowding Out

27
Q

What is the final effect of Increased G on Y and why?

A

Increased G –> Increased IS –> Movement along LM Curve –> Increased Y + r
BUT- Increased r –> Implies Decreased Investment
FINAL Effect on Y < (dG / 1-MPC)
Increased G ‘Crowds Out’ Private Sector

28
Q

What happens if Taxes Decrease?

A

Decreased Taxes –> Increased AD –> IS Curve Shifts to Right
BUT- Consumers save (1 - MPC) of Tax Cut
–> IS only Shifts by [(-MPC / 1 - MPC) x dT]
—-Crowding Out still Occurs
BUT- effect of dT on Y + r is Smaller than dG

29
Q

What policy affects the LM Curve?

A

Monetary Policy

30
Q

If the Central Bank (C.B) Increases the Money Supply, what happens to the LM Curve?

A

Increased M.S –> LM Curve Shifts to Right –> Decreased r + Increased Y
–> Decreased r –> Increased I

31
Q

What does the Effectiveness of Fiscal Policy depend on?

A

Depends on Relative Slopes of IS + LM Curves
—This Determines the Level of Crowding Out
Given slope of IS curve, STEEPER LM = LARGER Crowding Out
—-> Implies- FLATTER LM, ceteris paribus, MORE EFFECTIVE Fiscal Policy is

32
Q

Why does Flatter LM = More Effective Fiscal Policy?

A

Flat (elastic) LM Curve–> Implies (M/P)d is Very Sensitive to r / Very Insensitive to Income
–> Small Change in r–> Big Change in (M/P)d
OR–> Change in Income–> No Change in (M/P)d
If G Increases–> Y Increases–> Increased (M/P)d–> r Must Increase to restore Money Market Equilibrium
IF (M/P)d Very Sensitive to r, only Small Increase in r needed for Equilibrium–> Less Crowding Out

33
Q

For a Given Slope of LM Curve, when is Fiscal Policy More effective?

A

When IS Curve is STEEPER

34
Q

Why is Fiscal Policy More Effective with a STEEPER IS Curve?

A

IS Curve is Steeper (less elastic) if I is Insensitive to r

    • If G Increases–> Y Increased– Shift in IS determined by horizontal distance between ISo + IS1
  • ->If Y Increases–> Increased (M/P)d + r
  • -I Insensitive to r–> Small Negative effect on I from Increased r- Crowding Out is Small
35
Q

What does Slope of IS Curve depend on?

A

Sensitivity of I to IR

Higher Sensitivity = More Elastic- flatter IS Curve

36
Q

What does Slope of LM Curve depend on?

A

Sensitivity of Money Demand to IR

Higher Sensitivity of (M/P)d to IR = More Elastic- flatter LM Curve

37
Q

What are the functions from which IS + LM are derived?

A

IS: Y = A + c(Y-T) + Io -br + G

LM: [M/P] = kY - hr

38
Q

Given a Slope of IS Curve, when is Expansionary Monetary Policy more Effective?

A

When LM Curve is Less Elastic- STEEPER

39
Q

Why is Expansionary Monetary Policy more effective when LM Curve is Steeper?

A

Increased M.S–> Decreased r

  • -If LM Curve is Inelastic– (M/P)d is NOT Very Sensitive to r
  • -> To restore Equilibrium in Money Market– r Must Decrease a lot
  • -Big Impact on I–> Y affected- Y increase more where LM is Elastic
40
Q

Given a Slope of LM Curve, when is Expansionary Monetary Policy more Effective?

A

When IS Curve is more Elastic- FLATTER

41
Q

Why is Expansionary Monetary Policy more Effective when IS Curve is More Elastic?

A

Increased M.S–> Decreased r

–If I is Very Sensitive to r– Decreased r–> Big POSITIVE Effect on I–> Increased Y

Economics (20 decks)

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