IS-LM Model Flashcards by Jawad Ahmed

Define IS-LM

Explains how Fiscal + Monetary Policy affects Output + Interest Rates

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Consumption = Disposable Income Function

C = C(Y-T)

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IS Curve Assumption

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

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AD Keynesian Cross Function

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

—G + T are Exogenous

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Define the IS Curve

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

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What is the Keynesian Cross Function

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

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Derive the IS Curve from

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

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

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If r Decreases, what happens to Y?

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

–> Increased AD –> Increased Y

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What does the slope of the IS Curve mean?

Sensitivity of Y to IR

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Define the LM Curve

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

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If Y increases, what happens to r?

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

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What does L(Y, r) show?

Liquidity Preference

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If Liquidity Preference increases, what happens to Y?

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

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What does a Higher IR + Income Level cause?

Higher Liquidity Preference

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What does Liquidity Preference represent?

Demand for Money

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What is Money Demand sensitive to?

Output, Y

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What is Liquidity Preference Theory?

Implies a POSITIVE RELATIONSHIP between Output + IR

How does higher Income affect Money Demand?

Increased Income –> Increased Money Demand

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

Increased Income –> Increased Money Demand –> Increased IR

What is the Money Demand Function?

(M/P)d = kY - hr

Derive LM Curve from

(M/P)d = kY - hr

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

When the IS = LM, what is in Equilibrium?

Money Market = Goods Market

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

Equilibrium IR + Output, r* & Y*

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

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

What happens if G Increases?

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

What does Increased G cause?

Crowding Out

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

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

What happens if Taxes Decrease?

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

What policy affects the LM Curve?

Monetary Policy

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

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

What does the Effectiveness of Fiscal Policy depend on?

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

Why does Flatter LM = More Effective Fiscal Policy?

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

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

When IS Curve is STEEPER

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

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

What does Slope of IS Curve depend on?

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

What does Slope of LM Curve depend on?

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

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

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

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

When LM Curve is Less Elastic- STEEPER

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

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

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

When IS Curve is more Elastic- FLATTER

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

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