IS-LM Model and Phillips Curve

Question 1

What is the IS-LM model?

Answer 1

The IS-LM model is used to analyse the relationship between real output and interest rates in an economy, integrating both goods and money markets.

Question 2

What does “IS” stand for in the IS-LM model?

Answer 2

Investment-Savings, representing the goods market equilibrium where total planned investment equals total planned saving at various levels of output and interest rates.

Downward sloping due to interest rates negative effect on investment.

Question 3

What does “LM” stand for in the IS-LM model?

Answer 3

Liquidity-Money, representing the money market equilibrium where the demand for money equals the supply of money at different interest rates.

Upward sloping due to interest rates positive effect on money demand.

Question 4

What does a shift in the IS curve indicate?

Answer 4

Indicates changes in factors affecting planned investment or saving, such as changes in consumer confidence, business investment, or government policies.

Rightward shifts cause by, increased investment or decreased savings.

Question 5

What does a shift in the LM curve indicate?

Answer 5

Indicates changes in factors affecting the demand for money or the money supply, such as changes in central bank policies, financial market conditions, or public expectations about inflation.

Rightward shifts caused by increase in money supply and demand.

Question 6

What are some limitations of the IS-LM model?

Answer 6

Oversimplifies the complexity of real-world economies.

Model assumes fixed prices and wages, which may not hold true in practice.

Question 7

What affects money demand? (LM)

Answer 7

Interest rates - higher interest rates = decrease in MD, as opp. cost of holding money increases.

Income levels - positive correlation.

Inflation expectations - expect higher inflation = MD increase to preserve purchasing power.

Banking regulatory changes - restrictions on withdrawals or deposit policies can affect how much money to hold in accounts.

Econ uncertainty - job security or business prospects, higher uncertainty = hold more money increasing MD.

Question 8

What factors affect planned investment? (IS)

Answer 8

Interest rates - inverse relation.

Business confidence.

Tech innovation.

Expansionary fiscal policy.

Econ growth prospects.

Question 9

What factors affect planned savings? (IS)

Answer 9

Interest rates - positive correlation.

Income levels - positive correlation.

Demographic changes - ageing pop save more for retirement.

Consumer confidence - positive outlooks may encourage saving for future consumption.

Econ uncertainty - positive correlation.

Question 10

What causes movements on the IS-LM curve?

Answer 10

Changes in interest rates.

Question 11

What does the equilibrium point on the IS-LM curve represent?

Answer 11

Simultaneous equilibrium in both the goods market and the money market, where the levels of output (GDP) and interest rates are determined.

Question 12

What is the primary strength of the IS-LM model in economic analysis?

Answer 12

Integrates the goods market and the money market, providing a comprehensive view of how these markets interact to determine the equilibrium level of output and interest rates.

Question 13

How does the IS-LM model help in policy analysis?

Answer 13

The model is useful for analysing the effects of fiscal and monetary policy, showing how changes in government spending, taxation, and central bank actions influence economic activity and interest rates.

Question 14

Why is the IS-LM model well-suited for short-run analysis?

Answer 14

The IS-LM model is well-suited for short-run analysis because it assumes prices are sticky in short run, making it valuable for understanding short-term fluctuations in economic activity and the impact of policy interventions.

Question 15

What is a significant limitation of the IS-LM model regarding price assumptions?

Answer 15

The IS-LM model assumes fixed prices, which restricts its ability to explain inflation or deflation dynamics, as it does not account for price flexibility in the long run.

Question 16

What is a limitation of the IS-LM model in representing financial markets?

Answer 16

The LM curve simplifies the money market, not accounting for the complexity of modern financial markets, including the roles of financial intermediaries, asset markets, and expectations.

Question 17

How does IS-LM model’s focus on demand-side factors limit its usefulness?

Answer 17

Primarily focuses on demand-side factors like fiscal and monetary policy but neglects supply-side factors such as technology, labour productivity, and resource availability, which are crucial for long-term growth.

Question 18

How does the IS-LM model handle expectations and uncertainty?

Answer 18

Does not incorporate expectations and uncertainty effectively, which are significant factors influencing current economic behaviour.

Question 19

What key economic elements are not adequately addressed by the IS-LM model?

Answer 19

Inflation, technological progress, capital accumulation, labour force growth, and other factors that drive long-term economic development.

Question 20

Why is the IS-LM model limited in long-term economic analysis?

Answer 20

Does not provide insights into long-term economic growth and structural changes in the economy and assumes fixed prices, making it less useful for long-term analysis compared to models like the Solow growth model or endogenous growth theories.

Question 21

What is the overall effect of shifts in the IS and LM curves on the economy?

Answer 21

Shifts in the IS and LM curves change the equilibrium output and interest rates in the short run, influencing aggregate demand, which is reflected in shifts of the AD curve.

Question 22

What is the Sticky-price model and what is the assumption?

Answer 22

Firms do not instantly adjust prices in response to demand changes.

Assumption - monopolistic competition, firms set their own prices.

Question 23

Why are prices considered “sticky” in the sticky price model?

Answer 23

They do not adjust instantly due to factors like menu costs, long term contracts, and that firms do not want to annoy with frequent price changes.

Question 24

What is the impact of sticky prices on aggregate supply?

Answer 24

Sticky prices can show that the short-run aggregate supply curve is upward sloping, indicating that output can increase when prices are slow to adjust to higher demand.

Question 24

What are menu costs?

Answer 24

Costs associated with changing prices, such as reprinting menus, updating computer systems, and informing customers.

Question 25

What is adaptive expectations and how does it affect the Phillips curve?

Answer 25

An approach that assumes people form their expectations of future inflation based on recently observed inflation.

Suggest that people adjust their inflation expectations based on past inflation rates, influencing the short-run Phillips curve.

Question 26

What does the Phillips curve represent?

Answer 26

Represents the inverse relationship between the rate of unemployment and the rate of inflation in an economy.

Question 27

How does the short-run Phillips curve behave and how does it differentiate from the long run PC?

Answer 27

In the short run, lower unemployment can lead to higher inflation and vice versa.

The long-run Phillips curve is vertical, indicating that there is no trade-off between inflation and unemployment in the long run; it represents the natural rate of unemployment.

Question 28

Why is the long-run Phillips curve vertical?

Answer 28

Because in the long run, expectations adjust, and unemployment returns to its natural rate regardless of inflation.

Question 29

How do expectations affect the Phillips curve?

Answer 29

Expectations of future inflation can shift the short-run Phillips curve; if people expect higher inflation, the curve shifts upward, indicating higher inflation for any level of unemployment.

Question 30

What is the role of rational expectations in the Phillips curve?

Answer 30

Rational expectations imply that people use all available information to forecast inflation, potentially nullifying the trade-off between inflation and unemployment definitely in long run and even sometimes in the short run.

Question 31

What is the implication of the Phillips curve for monetary policy?

Answer 31

Implies that monetary policy can influence unemployment and inflation in the short run but is neutral in the long run due to the vertical long-run Phillips curve.

Question 32

How do supply shocks affect the Phillips curve?

Answer 32

Supply shocks, such as oil price increases, can shift the Phillips curve by increasing inflation and unemployment simultaneously,

Question 33

What are the types of inflation?

Answer 33

Demand-pull - positive demand shocks cause unemployment to fall below natural rate which causes inflation to increase. Positive Correlation.

Cost-push - typically from production costs increasing which causes higher prices causing higher inflation.

Question 34

What causes shifts in Phillips curve?

Answer 34

Changes in inflation expectations - expect higher rate then the SR PC shifts upward because demand higher wages and firms raise prices leading to higher rates at all levels of unemployment.

Supply shocks - adverse shocks (increase costs) = SR PC shift upward.

Changes in the natural rate of unemployment - Shift both LR and SR accordingly.

Structural changes in the economy - globalisation and regulatory changes can affect natural rate of unemployment.