ISLM Model/Keynesian Econ

Question 1

In the Keynesian Model how does the market adjust to be in equilibrium? Use excess supply as an example.

Answer 1

Output adjust - when supply is greater than demand, firms accumulate inventories and adjust production downwards

Question 2

What is the equation for the Keynesian cross?

Answer 2

Y = c0 + c1(Y-T) + I(r) + G

Question 3

The equilibrium position of the Keynesian cross is Y=AE, what happens if
1. Y<AE
2. Y>AE

Answer 3

1. firms have unplanned decumulation of inventories -> raise production -> higher output
2. firms have an unplanned accumulation of inventories -> lower production -> lower output

Question 4

What is the slope of the Keynesian cross (AE) ?

Answer 4

Marginal propensity to consume

Question 5

What is the government expenditure multiplier in the Keynesian Cross?

Answer 5

1/(1-marginal propensity to consume)

Question 6

What is the tax multiplier in the Keynesian Cross?

Answer 6

• MPC/(1-MPC)

Question 7

What is the equation for the IS schedule?

Answer 7

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

Question 8

What is the difference between the IS schedule and the Keynesian Cross?

Answer 8

Keynesian cross takes interest rates as exogenous, IS schedule takes interest rates as endogenous

Question 9

What causes a shift in the IS schedule? What causes a movement along it?

Answer 9

1. Shift = fixed variables e.g. government expenditure
2. Movemen t= interest rates

Question 10

What is the equation for the LM schedule?

Answer 10

M/P = L(Y, i), where M is determined exogrenously by the Bank and P is fixed

Question 11

What causes a shift in the LM schedule? What causes a movement along it?

Answer 11

1. Shift = changes in fixed variables e.g. money supply
2. Movement = interest rates

Question 12

How does the market adjust to equilibrium when there is equilibrium in the money market but no the good market and interest rates and income are below the equilibrium?

Answer 12

Have excess demand -> real income rises -> demand for money increases -> pressure on interest rate to rise -> return to equilibrium

Question 13

How does the market adjust to equilibrium when there is equilibrium in the goods market but not the money market and the interest rate is above equilibrium?

Answer 13

Excess supply in money market -> agents buy bonds -> interest rates fall -> so borrowing is incentive -> demand increases -> real income increases -> return to equilibrium

Question 14

Explain the concept of crowding out?

Answer 14

Government spending fails to increase overall aggregate demand because higher government spending causes an equivalent fall in private spending and investment through higher interest rates reducing investment and consumption

Question 15

What are net exports determined by in the open economy ISLM? (3)

Answer 15

1. Domestic income - increase in home income increase imports (decreases net exports)
2. Foreign income - increase in foreign income increases out exports (increases net exports)
3. Real exchange rate - appreciation of RER implies price of our good relative to foreign goods increases pushing down demand for our good (decreases net exports)

Question 16

What affect does a decrease in the RER have to the IS schedule?

Answer 16

Shifts it right/upwards

Question 17

What does the slope of the IS schedule depend on?

Answer 17

The responsiveness of investment to change in interest rates

Question 18

What does the slope of the LM schedule depend on?

Answer 18

The responsiveness of money demand to change in income