ISLM model Flashcards
Define exchange rate.
The price of one unit of foreign currency in terms of domestic currency
What does the money demand curve look like?
Sloping downwards
What causes a shift in the money demand curve?
Changes in income
What is the another way to talk about the demand for money?
Liquidity
What are the two options for liquidity we talk about?
Holding bonds or money in your hands
Does holding bonds or money mean you demand less money?
Bonds
What does the money supply curve look like?
Vertical line
Draw the money supply and money demand curves.
Picture
Who controls money supply?
Central banks
Why is money supply deemed to be exogenous?
It is a policy action chosen by central banks so decided outside of the model.
What do central banks carry out to shift the money supply curve?
Open market operations
What is the formula for the rate of return of a bond?
(walue of the bond - what your buy it for)/ what you bought it for
Why can the rate of return of saving your money and bonds never be too far apart?
Because of one increases it causes the other one to increase also
What is the symbol for rate of return on a bond and of your savings?
iB, ID
What does CU stand for?
The amount of currency held by the public
What does CRES stand for?
The currency reserves held by central banks
What does M0 stand for?
Monetary base
What is M0 equal to?
CU + CRES
What does DEP stand for?
The amount of money held in someones account
What are the axis for the money supply and demand curves?
i and money
How do you derive the LM curve?
Draw the money supply and demand curve on one graph, then increase the income and shift the money demand curve, then trace this increase in interest rate and plot it against income to get the LM curve.
Draw a LM curve.
Picture
What is LM the locus of points for?
Of equilibrium in the different income and interest space
What are the axis for the LM curve?
Income and interest rate
What is the equation for money demand?
L = kY - hi
What is the equation for money supply?
M = Ḿ
How can you derive the equation for the LM curve?
sub L=M into the money demand function and rearrange to make i the subject
What is the equation for the LM curve?
i = -M/h + (k/h)Y
Define the LM curve.
The LM curve identifies combinations of income and the interest Arte for which the demand for money equals the money supply
What does IS curve stand for?
Investment and saving curve.
How can you derive the equation for the IS curve?
Y = AE,m then range to be i the subject
What is the equation for the is curve.
i = (Ī + g)/b - ((1-c)Y)/b
What slopes do the IS and LM curves have?
IS - negative
LM - positive
How would an increase in government expenditure affect the iS curve?
Shift it to the right
What does b stand for?
The sensitivity of investment to the interest rate
Draw the ISLM curve.
Picture
How do you derive the IS curve?
Draft the AE curve and then increase the interest rate to shift the curve upwards, trace the increase in income and plot it against the interest rate increase.
How do you find the government multiplier or the money multiplier?
Differentiate Y partially with respect to the corresponding variable
Name three reasons we demand money.
- ) Transactions
- ) Precautionary motive
- ) Speculative motive
What is meant by precautionary motive?
Want to have cash in your pockets to take advantage of unseen purchases
What is meant by speculative motive?
By holding cash you forego the rate of return of bonds, by holding bonds you forego the liquidate money.
Why does the interest act negatively on demand?
The higher the interest rate the less I am going to gold cash because of the possible return
Define monetary policy.
Monetary policy manipulates the money supply (or interest rate) to achieve policy goals (such as a rise in income)
Define fiscal policy.
Fiscal policy manipulates government spending and taxes to achieve policy goals (such as a rise in income)
What curves do monetary policies effect?
The LM curve
What curves of fiscal policies effect?
The IS curve
If the IS curve fluctuates due to shocks what is the effect of the central bank fixing money supply?
The movement in the IS causes the income to fluctuate also
If the IS curve fluctuates due to shocks what is the effect of the central bank fixing the interest rate?
The LM curve must move to the intersection of the fixed interest rate and the shifted IS curve causing the income to fluctuate a lot
If the LM curve fluctuates due to shocks what is the effect of the central bank fixing money supply?
The movement in the LM causes the income to fluctuate also
If the LM curve fluctuates due to shocks what is the effect of the central bank fixing the interest rate?
The equilibrium is at the fixed interest rate and the IS so there is no change in the income
What is an example of an open market operation?
Buying bonds
How does an increase in money supply effect the LM curve?
Shifts it to the right
Why does increasing the money supply drive cause a new equilibrium to occur.
At the current equilibrium there will be an excess supply of money. At their current income level Individuals do not want to hold the amount of money supplied by the central banks. This drives down the holding price of money, the interest rate. At the current income level and the new interest rate firms perceive an excess demand for their goods and services, stepping up production and raising income, This process continues until a new overall equilibrium obtains at a lower interest rate and higher income.
How does an increase in government expenditure effect the IS curve.
It shifts the IS curve to the right.
Why does increasing government expenditure cause a new equilibrium to occur?
The additional demand created by the government creates demand for goods. To restore equilibrium in the goods market, either the interest rate must rise to drive down investment demand or firms must produce more raising income. This means the new equilibrium has a higher interest rate and income.
What is one simplification of the money market?
That demand for liquidity is linear
What is the real shape of the curve for demand for money?
Downward sloping curve
Draw the real case for the demand for money.
Picture
Why is there a horizontal asymptote in the real demand for money curve?
As the interest rate becomes lower and approaches zero the demand for liquidity tends to infinity as you keep your cash in your hand as there is no interest/ incentive to store it in banks
Why is there a vertical asymptote in the real demand for money curve?
No matter the interest rate a bit of money is always demanded for transcations
What is the critical rate of the bond?
When the price of the bond is as high as it can possibly go so you sell it
What is the horizontal asymptote in the demand for money curve called?
The liquidity trap
What is the liquidity trap?
The point in which you keep all your money liquid
What becomes ineffective in the liquidity trap?
Monetary policies
If income increases what happens to the real demand for money curve?
Translations side ways, shifted to the right
Why are we able to use the linear form of the demand for money curve?
The IS curve tends to cross the LM curve in the region which is approximately a straight line so we can simplify it to one
In the vertical part of the real LM curve (high interest rate and income) which policies are more effective? And why?
Monetary policies, as they shift the LM curve which causes a big effect on the income and little on interest rate. Fiscal policies shift the IS curve however that has minimal effect on the income.
In the horizontal part of the real LM curve (low interest rate and income) which policies are more effective? And why?
Fiscal policies as a shift in the IS curve will cause a big effect on income and little on the interest rate. Monetary policies shift the LM curve which has minimal effect on the income.
How does an increase in speculative demand for money effect the LM curve?
It shifts it to the left
How does collapsing consumer confidence effect the LM curve?
It shifts it to the left
What do consumers demand from banks?
A risk premium which is interest rate
Define risk premium.
The risk premium is the difference between the risk-free interest rate and the expected return on an alternative risky asset.
What does a risk premium cause to the LM curve?
It to shift upwards
What policies do you have to use in the liquidity trap?
Fiscal policies
Why can interest rate never go very negative?
Because you would just keep the money in liquid form
Why can the rate of return on a bond go negative?
If the bond pays out less than you paid then you will be losing money and so negative rate of return
When we endogenies imports what do we set imports equal to?
IM = mY
Why do you treat exports similar to imports? And what is the equation?
Our experts are someone else imports: EX = x1Y*
What does Y* stand for?
Foreign income
What do we assume about our economy relative to the rest of the world?
It is relatively small
What does R stand for? and what is it equal to?
Price competitiveness: R = EP* / P
What creates a large R?
If our price is lower than the competitors
What are the two ways to define exchange rate?
Nominal exchange rate and inverse exchange rate
What is the difference between nominal exchange rate and inverse exchange rate?
Nominal is how many units of domestic currency is needed to buy one unit of foreign currency where as the inverse exchange is the opposite
How does the nominal exchange rate change when you are more competitive, large R value?
It increases
What does depreication mean in terms of sterling and euros?
You need more sterling to purchase the same amount of euros
What is the effect on exports when our competitiveness increases?
Exports also increase
What is the equation for exports that include competitiveness ?
EX = x1Y* + (x2E£/€ P*€)/P£
What is the equation for imports that include competitivness?
IM = m1Y - (m2E£/€ P*€ /P£)
When there is a depreciation in the nominal exchange rate what happens to the IS curve?
Will shift to the right
When there is a appreciation in the nominal exchange rate what happens to the IS curve?
Will shift to the left
What happens to exports and imports if sterling depreciates?
Exports increase and imports become more expensive and so decrease
What is a third conditional equilibrium we introduce to the ISLM model?
FE line
What does the FE line stand for?
Foreign exchange line
What does CA stand for?
Balance of the current account
What does KP stand for?
Balance of the capital account
What is the current account equilibrium?
When EX = IM
Define the FE curve.
The FE curve identifies combinations of income and the interest rate for which the foreign exchange market is in equilibrium
What does BP = ?
CA + KP?
Draw CA and KP on one graph.
Picture
Where is there massive capital inflows in relation to the KP line?
Above the line
If capital account of current account for important?
Capitals
Where is the capital account more responsive in terms of time compared to the current account?
Current account relates imports and exports, to takes time for changes and is slow to react, where as capital account relates to interest rates which can change at any point
Draw the ISLM, BPFE line on one graph.
Picture
What is another name for the IS-LM-FE model?
Mundell-Fleming model
What are the two types of exchange rates you have to consider in the IS-LM-FE model?
Fixed exchange rates and flexible exchange rate
What is the main difference between the fixed and flexible exchange rate?
Fixed is entirely controlled by the banks where as flexible they have no control
What does devaluation mean?
You increase the parity, you get less for the pound
What does revaluation mean?
You decrease the parity, more for the pound
What is meant by a flexible exchange rate?
When governments allow the exchange rate to be determined by market forces alone.
What is meant by fixed exchange rate?
When government or central banks announce an exchange
What happens when there is a fixed exchange rate, and there are fiscal expansionary policies?
Fiscal expansionary policies shift the IS curve to the right, rise in domestic interest rate means we are above the FE line, return higher on UK bonds compared to foreign bonds. Central bank builds up stores of foreign current and gives out more domestic currency increasing the monetary base which shifts the LM curve to the right. This means income has increased a lot with no effect on interest rate
Show the effect of fiscal policies on a fixed exchange rate on a graph.
Picture
What happens when there is a fixed exchange rate, and there are monetary expansionary policies?
Monetary expansionary policies means and increase in money supply and so the LM curve shifts to the right, fall in domestic interest rate means we are below the FE line, rate of return on foreign bonds is higher. So people go to the central bank and ask for foreign currency. Meaning the domestic monetary base shrinks and the LM curve shifts back to its original point
Show the effect of monetary policies on a fixed exchange rate on a graph.
Picture.
What happens when there is a flexible exchange rate, and there are fiscal expansionary policies?
Fiscal expansionary policies shift the IS curve to the right, rise in domestic interest rate means we are above the FE line, return higher on UK bonds compared to foreign bonds however the banks won’t do anything. There will be a higher demand for domestic currency and so appreciation. This depresses exports as domestic goods are now too expensive so the IS curve shifts back to its original point.
Show the effect of fiscal policies on a flexible exchange rate on a graph.
Picture
What happens when there is a flexible exchange rate, and there are monetary expansionary policies?
Monetary expansionary policies means and increase in money supply and so the LM curve shifts to the right, fall in domestic interest rate means we are below the FE line, there will be capital outflow and an increased demand for foreign currency. This depreciates the value of the domestic currency increases exports as domestic goods have become less expensive. IS curve will shift the right and so you have an increase in income and no change in interest rate.
Show the effect of monetary policies on a flexible exchange rate on a graph.
Picture.
Which policy is effective in a fixed exchange?
Fiscal policy
Which policy is ineffective in a fixed exchange rate?
Monetary policy
Which policy is effective in a flexible exchange rate?
Monetary policy
Which policy is ineffective in a flexible exchange rate?
Fiscal policy
What is a loose independent monetary policy?
Where the economy does as the rest of the world
What do foreign banks do to prevent depreciation?
Buy own currency and sell foreign
What do foreign banks do to prevent appreciation?
Sell own currency and buy foreign
If you have flexible exchange rates what equations do you have to equate to determine equilibrium?
LM and FE
If you have fixed exchange rates what equations do you have to equate to determine equilibrium?
IS and FE
