lecture 5 Flashcards
What is the fundamental relation represented by the IS curve in the goods market?
The IS curve represents the equilibrium where production (Y) equals demand for goods (Z). It shows combinations of interest rates and output where the goods market is in equilibrium.
What two factors affect investment in the IS relation?
- Positively: Level of sales (higher sales increase investment).
- Negatively: Interest rate (higher interest rates reduce investment).
How does an increase in the interest rate affect the IS curve?
An increase in the interest rate reduces demand and consequently lowers the equilibrium level of output, resulting in a downward-sloping IS curve.
What causes the IS curve to shift to the right?
The IS curve shifts to the right due to:
* Higher government spending (G↑)
* Lower taxes (T↓)
Both factors increase the demand for goods.
What assumptions are made when deriving the LM curve?
- The Central Bank sets the interest rate, not the money supply.
- The interest rate set by the Central Bank affects the rate at which banks lend.
- The money supply (M) adjusts to meet money demand at the chosen interest rate.
Why is the LM curve flat under current monetary policy assumptions?
The LM curve is flat because the interest rate is fixed by the Central Bank. As income increases, money demand rises, but the Central Bank adjusts the money supply to keep the interest rate constant.
How do fiscal and monetary contractions affect the IS-LM model?
- Fiscal contraction (T↑ or G↓): Shifts the IS curve left, reducing output.
- Monetary contraction (i↑): Shifts the LM curve upward, increasing interest rates and lowering output.
What is the effect of an expansionary monetary policy on the IS-LM model?
Expansionary monetary policy reduces the interest rate (i↓), which stimulates investment. This increase in investment raises aggregate demand and output, moving the equilibrium along the IS curve.
How can a policy mix involving fiscal expansion and monetary contraction affect output and interest rates?
- Fiscal expansion (G↑ or T↓): Shifts IS curve right, increasing output and interest rates.
- Monetary contraction (i↑): Shifts LM curve up, raising interest rates and reducing output. The final outcome depends on the relative magnitude of both policies, as they act in opposite directions.
