IS-LM Model

Question 1

Define IS-LM

Answer 1

Explains how Fiscal + Monetary Policy affects Output + Interest Rates

Question 2

Consumption = Disposable Income Function

Answer 2

C = C(Y-T)

Question 3

IS Curve Assumption

Answer 3

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

Question 4

AD Keynesian Cross Function

Answer 4

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

—G + T are Exogenous

Question 5

Define the IS Curve

Answer 5

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

Question 6

What is the Keynesian Cross Function

Answer 6

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

Question 7

Derive the IS Curve from

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

Answer 7

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

Question 8

If r Decreases, what happens to Y?

Answer 8

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

–> Increased AD –> Increased Y

Question 9

What does the slope of the IS Curve mean?

Answer 9

Sensitivity of Y to IR

Question 10

Define the LM Curve

Answer 10

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

Question 11

If Y increases, what happens to r?

Answer 11

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

Question 12

What does L(Y, r) show?

Answer 12

Liquidity Preference

Question 13

If Liquidity Preference increases, what happens to Y?

Answer 13

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

Question 14

What does a Higher IR + Income Level cause?

Answer 14

Higher Liquidity Preference

Question 15

What does Liquidity Preference represent?

Answer 15

Demand for Money

Question 16

What is Money Demand sensitive to?

Answer 16

Output, Y

Question 17

What is Liquidity Preference Theory?

Answer 17

Implies a POSITIVE RELATIONSHIP between Output + IR

Question 18

How does higher Income affect Money Demand?

Answer 18

Increased Income –> Increased Money Demand

Question 19

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

Answer 19

Increased Income –> Increased Money Demand –> Increased IR

Question 20

What is the Money Demand Function?

Answer 20

(M/P)d = kY - hr

Question 21

Derive LM Curve from

(M/P)d = kY - hr

Answer 21

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

Question 22

When the IS = LM, what is in Equilibrium?

Answer 22

Money Market = Goods Market

Question 23

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

Answer 23

Equilibrium IR + Output, r* & Y*

Question 24

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

Answer 24

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

Question 25

What happens if G Increases?

Answer 25

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

Question 26

What does Increased G cause?

Answer 26

Crowding Out

Question 27

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

Answer 27

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

Question 28

What happens if Taxes Decrease?

Answer 28

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

Question 29

What policy affects the LM Curve?

Answer 29

Monetary Policy

Question 30

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

Answer 30

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

Question 31

What does the Effectiveness of Fiscal Policy depend on?

Answer 31

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

Question 32

Why does Flatter LM = More Effective Fiscal Policy?

Answer 32

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

Question 33

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

Answer 33

When IS Curve is STEEPER

Question 34

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

Answer 34

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

Question 35

What does Slope of IS Curve depend on?

Answer 35

Sensitivity of I to IR | Higher Sensitivity = More Elastic- flatter IS Curve

Question 36

What does Slope of LM Curve depend on?

Answer 36

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

Question 37

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

Answer 37

IS: Y = A + c(Y-T) + Io -br + G LM: [M/P] = kY - hr

Question 38

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

Answer 38

When LM Curve is Less Elastic- STEEPER

Question 39

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

Answer 39

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

Question 40

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

Answer 40

When IS Curve is more Elastic- FLATTER

Question 41

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

Answer 41

Increased M.S--> Decreased r | --If I is Very Sensitive to r-- Decreased r--> Big POSITIVE Effect on I--> Increased Y