Term 1 Lecture 7: Goods and Financial Markets

Question 1

What do we assume about the short vs long run (2)

Answer 1

-In the short run prices are fixed, but in the long run they are variable
-In the short run, any nominal and real changes are the same, and the real IR = nominal

Question 2

What do IS and LM mean (2,1)

Answer 2

-IS: Investment = Saving
-LM: Liquidity preference = Money supply

-IS = LM Is where there is equilibrium in the financial and goods markets

Question 3

What is the IS relation (3)

Answer 3

-Y = C(Y-T) + I(Y, i) + G
-This is equilibrium in the goods market
-I(Y, i) means Investment positively depends on production, and negatively on sales

Question 4

How do we derive the IS Curve (2, 2)

Answer 4

-With Output on the x axis, and Demand on the Y axis, plot a 45 degree line and an upwards sloping demand curve
-This demand curve doesn’t start from the origin (autonomous consumption) and is <45 degrees (increase in output = less than one for one increase in demand)

-The IS curve is a downwards sloping curve, with output on the x axis, and IR on the Y axis
-Downwards sloping as an increase in IR = decrease in C and I = decrease in demand = decrease in output (Put the ZZ diagram on top of the IS one)

Question 5

How do we derive the LM curve (2,4)

Answer 5

-If we remember M = $YL(i) (money supply = money demand), and divide everything by the price level P, we get M/P = YL(i)
-In equilibrium, real money supply = real money demand, which depends on real income Y and the decreasing function if the interest rate L(i)

-Remember the money supply = money demand diagram, with real money on the x axis, and interest rates on the y axis
-The LM curve is a upwards sloping curve, with output on the x axis, and IR on the Y axis
-Increase in output = increases in demand for money = increase in IR (assuming Ms is constant) (Put the 2 diagrams next to eachother)
-An increase in money supply causes the LM curve to shift down

Question 6

How does the LM curve shape change depending on how the central bank acts (2)

Answer 6

-If the central bank chooses the money supply, the LM curve is upwards sloping
-If the central bank chooses the IR (more common), the LM curve becomes a horizontal line, and money supply adjusts to achieve it

Question 7

How can we put the IS and LM curve together (3,1)

Answer 7

-Any point on the IS curve corresponds to equilibrium in the goods market
-Any point on the LM curve corresponds to equilibrium in financial markets
-Only at their intersection are both relations satisfied

-As the IS curve depends on the real IR, LM depends on the nominal, we can only draw these together when assuming r = i

Question 8

What is a monetary-fiscal policy mix (2,2)

Answer 8

-A monetary-fiscal policy mix is the combination of monetary and fiscal policies
-Sometimes the right mix is to use them in the same direction, sometimes in the opposite

-Fiscal policy affects the IS curve
-Monetary policy affects the LM curve

Question 9

What are the impacts it taking time to adjust output (2,1)

Answer 9

-Consumers are likely to take their time to adjust consumption following a change in disposable income
-Firms are likely to take their time to adjust investment spending following a change in sales/IR, and take time to adjust production following a change in sales

-In the short run, an increase in the federal funds rate (base rate) leads to a decrease in output, rise in unemployment, but little effect on the price level