IS-LM Model and Phillips Curve Flashcards
What is the IS-LM model?
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.
What does “IS” stand for in the IS-LM model?
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.
What does “LM” stand for in the IS-LM model?
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.
What does a shift in the IS curve indicate?
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.
What does a shift in the LM curve indicate?
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.
What are some limitations of the IS-LM model?
Oversimplifies the complexity of real-world economies.
Model assumes fixed prices and wages, which may not hold true in practice.
What affects money demand? (LM)
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.
What factors affect planned investment? (IS)
Interest rates - inverse relation.
Business confidence.
Tech innovation.
Expansionary fiscal policy.
Econ growth prospects.
What factors affect planned savings? (IS)
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.
What causes movements on the IS-LM curve?
Changes in interest rates.
What does the equilibrium point on the IS-LM curve represent?
Simultaneous equilibrium in both the goods market and the money market, where the levels of output (GDP) and interest rates are determined.
What is the primary strength of the IS-LM model in economic analysis?
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.
How does the IS-LM model help in policy analysis?
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.
Why is the IS-LM model well-suited for short-run analysis?
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.
What is a significant limitation of the IS-LM model regarding price assumptions?
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.
What is a limitation of the IS-LM model in representing financial markets?
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.
How does IS-LM model’s focus on demand-side factors limit its usefulness?
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.
How does the IS-LM model handle expectations and uncertainty?
Does not incorporate expectations and uncertainty effectively, which are significant factors influencing current economic behaviour.
What key economic elements are not adequately addressed by the IS-LM model?
Inflation, technological progress, capital accumulation, labour force growth, and other factors that drive long-term economic development.
Why is the IS-LM model limited in long-term economic analysis?
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.
What is the overall effect of shifts in the IS and LM curves on the economy?
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.
What is the Sticky-price model and what is the assumption?
Firms do not instantly adjust prices in response to demand changes.
Assumption - monopolistic competition, firms set their own prices.
Why are prices considered “sticky” in the sticky price model?
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.
What is the impact of sticky prices on aggregate supply?
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.
What are menu costs?
Costs associated with changing prices, such as reprinting menus, updating computer systems, and informing customers.
What is adaptive expectations and how does it affect the Phillips curve?
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.
What does the Phillips curve represent?
Represents the inverse relationship between the rate of unemployment and the rate of inflation in an economy.
How does the short-run Phillips curve behave and how does it differentiate from the long run PC?
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.
Why is the long-run Phillips curve vertical?
Because in the long run, expectations adjust, and unemployment returns to its natural rate regardless of inflation.
How do expectations affect the Phillips curve?
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.
What is the role of rational expectations in the Phillips curve?
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.
What is the implication of the Phillips curve for monetary policy?
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.
How do supply shocks affect the Phillips curve?
Supply shocks, such as oil price increases, can shift the Phillips curve by increasing inflation and unemployment simultaneously,
What are the types of inflation?
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.
What causes shifts in Phillips curve?
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.
