IS-LM Model Flashcards
Define IS-LM
Explains how Fiscal + Monetary Policy affects Output + Interest Rates
Consumption = Disposable Income Function
C = C(Y-T)
IS Curve Assumption
Investment depends NEGATIVELY on Interest Rates- Increased IR –> Decreased Investment
-Due to Opportunity Cost
AD Keynesian Cross Function
AD = C(Y-T) + I(r) + G,
—G + T are Exogenous
Define the IS Curve
Schedule of all combinations of r + Y that result in Goods market Equilibrium
What is the Keynesian Cross Function
Y = A + c(Y-T) + Io - br + G
Derive the IS Curve from
Y = A + c(Y-T) + Io - br + G
r= 1/b [A + Io + G - (1-c)Y - cT]
If r Decreases, what happens to Y?
Decreased r –> Increased I - due to lower cost of borrowing
–> Increased AD –> Increased Y
What does the slope of the IS Curve mean?
Sensitivity of Y to IR
Define the LM Curve
Schedule that gives all combinations of Y and r that insure Equilibrium in Money Market
If Y increases, what happens to r?
Increase Y –> Increased Money Demand [L(Y, r)] –> Increased r
What does L(Y, r) show?
Liquidity Preference
If Liquidity Preference increases, what happens to Y?
Increased L.P –> Increased r –> Increased Y
What does a Higher IR + Income Level cause?
Higher Liquidity Preference
What does Liquidity Preference represent?
Demand for Money
What is Money Demand sensitive to?
Output, Y
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
