The IS/LM Model Flashcards
What is the IS/LM Model?
Shows how interest rates (i) and income/output (Y) are jointly determined. It’s an extension of the Keynesian model and assumes fixed prices, unemployed resources, a closed economy, and short-run analysis.
What does the IS Curve represent?
Represents combinations of interest rates and income where the goods market clears (i.e. Investment = Savings). Investment is negatively related to interest rates, leading to a downward slope.
What causes shifts in the IS curve?
Shifts occur due to changes in autonomous spending (e.g. government spending, taxes, consumer confidence).
What is the key idea of the IS curve?
IS curve captures how interest rates affect spending and output in the goods market.
What does the LM Curve represent?
Represents combinations of interest rates and income where money demand equals money supply, based on Keynes’ Liquidity Preference Theory.
What is the key idea of the LM curve?
LM curve is upward sloping because higher income leads to higher demand for money, which raises interest rates.
Where is equilibrium found in the IS/LM Model?
At the intersection of the IS and LM curves — where both markets are in equilibrium, providing the equilibrium level of income (Y) and the interest rate (i).
How does fiscal policy affect the IS curve?
Increase in government spending (G) shifts IS right → higher Y and i. Decrease in G shifts IS left → lower Y and i.
What is the effect of increased income on money demand?
As income increases, money demand increases, leading to rising interest rates and potentially falling investment (crowding out).
When is fiscal policy more effective?
Fiscal policy is more effective when the LM curve is flat, meaning money demand isn’t very interest-sensitive.
How does monetary policy affect the LM curve?
Increase in money supply shifts LM right → interest rates fall, income rises. Decrease in money supply shifts LM left → interest rates rise, income falls.
When is monetary policy more effective?
Monetary policy is more effective when the IS curve is flat, meaning investment is highly interest-sensitive.
How do fiscal and monetary policies interact?
They can reinforce or offset each other. Monetary accommodation can support fiscal expansion, preventing interest rates from rising and crowding out investment.
What is the relationship between policies and their effectiveness?
Fiscal Policy is more effective when LM is flat (interest rate doesn’t rise much with income). Monetary Policy is more effective when IS is flat (investment responds strongly to interest rate).
How does the IS/LM model relate to the Aggregate Demand (AD) curve?
The IS/LM model helps derive the AD curve. A fall in the price level increases real money balances, shifts the LM curve right, and increases output, resulting in a downward sloping AD curve.
