ISLM, PDV, Risk, Money Supply, Interest Rates

Question 1

Show an increase in interest rates on the Keynesian Cross Diagram

Convert this onto an IS curve

Answer 1

Question 2

How does an increase in taxes affect the IS curve?

Answer 2

An increase in taxes shifts the IS curve to the left.

As the IS curve is downward sloping, equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output.

Shifting the IS curve: Changes in factors that decrease (increase) the demand for goods given the interest rate shift the IS curve to the left (right).

Question 3

Explain the terms, money supply and money demand?

Answer 3

The money supply is controlled by the central bank, the central bank can choose to adjust the interest rate to set the money supply or adjust the money supply (by selling bonds) to set the interest rate, in modern day we pretty much only see the first option.

Money demand is the demand for central banks money by the other banks for their reserves.

Real money supply = real money demand

Question 4

What is the difference between nominal money supply and real money supply?

Answer 4

The nominal money supply is the supply of money controlled by the central bank before it has been deflated by P to account for inflation.

The real money supply has been deflated by price level P.

Question 5

What is the LM curve?

Answer 5

A flat curve, showing the equilibrium in financial markets, it varies directly with the interest rate.

Question 6

What is the equation for Money supply = money demand?

Answer 6

M = $Y L(i)

Question 7

State the equation for “real money supply = real money demand”?

Answer 7

M/P = YLi

L(i) = Interest Rate

Y = Real Income

This is reached by dividing both sides of the nominal equation by P.

$Y/P = Y (I think the dollar sign just shows it’s nominal)

Question 8

What is the equation for the IS relation?

Answer 8

IS Relation:

Y = C(Y-T) + I(Y,i) + G

Question 9

What is the equation for the LM relation?

Answer 9

Question 10

What can you find when you put the IS and LM relations together on a graph?

What does each line represent?

Answer 10

• The LM curve represents equilibrium in financial markets
• The IS curve represents equilibrium in the goods market
• Where they cross is output and the current interest rate

This can be used to analyse the effects of changed in policy or exogenous variables:

1. Does it shift the IS curve and/or the LM curve?
2. What does this do to equilibrium output and the equilibrium interest rate?

Question 11

What is the purpose of the ISLM model?

Answer 11

To link goods markets with financial markets via interest rates

Question 12

How will an increase in taxes affect the ISLM graph?

Answer 12

An increase in taxes shifts the IS curve to the left. This leads to a decrease in the equilibrium level of output.

Question 13

Define monetary expansion and contraction, how will these affect the ISLM graph?

Answer 13

Monetary expansion is an increase in investment

Monetary contraction is an increase in “i” and a decrease in “M” (also called monetary tightening)

Question 14

What is the drawback of this theoretical ISLM model currently?

How can we adjust for this?

Answer 14

The economy is slow to adjust to policy changes, the model doesn’t show how long it takes to go from one equilibrium to the next.

Y = Actual Output

Y^*= Theoretical Equilibrium Output

Question 15

Explain a second drawback of the ISLM model?

Answer 15

Needs another way of linking financial and goods markets (another “channel”)

• In reality, there is more than just interest rates affecting this relationship
• In order to see these extra things we must look at:
  
  • The value of an asset
  • The role of financial assets
  • Nominal vs real interest rates
  • Risk and Risk Premia

Question 16

List the 3 properties of a good asset:

Answer 16

• Cheap to store
• Durable
• Reasonably Liquid
  
  • E.g. Financial: Stocks, bonds and futures contracts or, non-financial: Gold, art, fine wine, property.

Question 17

Explain the 3 functions of asset markets:

Answer 17

• They put a price on Deferred utility: The price of lending today vs tomorrow, defined by the equilibrium in financial markets
• They serve as a financial intermediator, they connect savers to investors
• Allocating price and risk, financial markets allow participants to choose the riskiness of their portfolios.

Question 18

Explain present discounted value, there is another card for the equation.

Answer 18

Present discounted value is about finding the value of an investment where inflation is accounted for.

A.k.a - The value of its payments in today’s money

Question 19

What is the equation for PDV?

Answer 19

The second equation is for a share that gives dividends.

Question 20

What is a financial intermediary and what is their role?

Answer 20

Basically a bank.

Funds from investors–> financial intermediaries–> Others

Question 21

What ratios do financial intermediaries use?

Answer 21

• Capital Ratio, ratio of capital to assets
• Leverage Ratio, ratio of assets to capital
  
  • Higher leverage ratio implies higher expected profits but also a higher risk of insolvency and bankruptcy.

Question 22

2 Factors that determine risk premia?

Answer 22

• The probability of default (p)
• The degree of risk aversion among asset holders
  
  • Links to the extra interest required by lenders to hold the risky asset (x)

Question 23

What does a portfolio equation for an investment where there is risk look like?

Answer 23

Question 24

(check) What is the real interest rate?

Answer 24

The interest rate in the planned year minus inflation for that year, this is sometimes called the “before the fact” interest rate.

When expected inflation = 0 the nominal and real interest rates are the same.

i_t = Nominal Interest Rate for this year (the one announced by BOE)

π^e_t+1 = Expected inflation for next year

r_t= Real interest rate

Question 25

(check) What is the realised interest rate?

Answer 25

The nominal interest rate minus inflation

(i-π_t+1)

Question 26

How does risk premia affect the ISLM relation?

Answer 26

Remember: x is the extra interest required by lenders to hold the risky asset.

Question 27

How does risk premia affect the ISLM relation on a graph?

Answer 27

Question 28

What is a liquidity trap?

Answer 28

Where interest rates are so low that they cannot be lowered further.

Question 29

What did the financial crisis look like on an ISLM diagram?

Answer 29