The IS LM Model-Keynesian

Question 1

Key assumptions of Keynesian model/cross (2)

Answer 1

Wages and prices are sticky (fixed in short run)
Closed economy (Y=C+I+G)

Question 2

Circular flow of income for a closed economy

Answer 2

Output=income=expenditure

Question 3

Planned (e) vs actual expenditure (y)

Answer 3

How much agents want to spend, vs how much they actually spend

Question 4

How do we capture intended spending actions (planned expenditure)

Answer 4

Planned expenditure (e) =Aggregate demand

Question 5

Which is the only variable of the expenditure components that varies with output?

Answer 5

Consumption.

Question 6

What does the planned expenditure diagram look like+ axis

Answer 6

Upward sloping line- as consumption and disposable income share a positive relationship, so it slopes up.

Note: intercept on E is higher than just the consumption function as I+G too

Planned expenditure (E) on y axis
Actual output (y) on x axis

Question 7

45 degree line

Answer 7

The 45 degree line represents cases where planned expenditure and actual output/actual expenditure would be equal (“E=Y”)

The point at which the planned expenditure line meets the 45 degree line is the point of equilibrium in the model. This is where intended spending (E = C + I + G) coincides with an actual realised outcome (Y)

Question 8

What happens in disequilibrium (planned>actual)

Answer 8

Planned>actual-Excess demand of goods and services (AD>Aggregate output)

Actual>Planned-excess supply of goods and services

Question 9

Keynes intuition

Answer 9

firms produce the quantity of goods & services they think economic agents plan to purchase – hence the emphasis on planned expenditure

I.e if spending falls, sales fall while inventories rise so firms reduce production

Question 10

Inventories if firms sell more than expected

Answer 10

Stock of inventories falls. (Unsold goods are used to meet excess demand)

Question 11

Inventories if firms sell less than expected

Answer 11

Stock of inventories build up.

If there is excess supply, inventories build up.

Question 12

What firms do when planned expenditure>output

Answer 12

Excess demand.
Firms reduce inventories to satisfy demand thus increasing production so actual output increase

Question 13

What do firms do if planned expenditure is less than actual output

Answer 13

Excess supply.
Firms inventories increase
Firms reduce production so actual output falls

Question 14

Unplanned inventories diagram….

Answer 14

Draw the planned and actual line.

The first part is where planned>actual (demand is greater than output) so the gap in between them is a UNPLANNED fall in inventories, as inventories are used to meet excess demand.

2nd part: where actual overtakes the planned expenditure line, means output is greater than demand, creating excess supply. Therefore the gap in between the 2 lines represent the UNPLANNED inventory accumulation

Question 15

Expansionary fiscal policy on planned expenditure and what it looks like on diagram

Answer 15

Increase in gov spending or a fall in taxes, increase planned expenditure. (SHIFT UPWARDS OF P)

To satisfy this higher demand, firms use their inventories, causing an unplanned drop in inventories, and so they then have to increase their output to replenish the inventories- output rises y1>y2

A multiplier effect also occurs…
On the diagram, Y axis shows a change in G, X axis shows change in Y. GPM shows how much Y changes following a change in G

Question 16

Government purchases Multiplier definition and formula

Answer 16

How much income (Y) changes in response to a change in government spending (G)

Change in y/ Change in G = 1/1-MPC

E.g if gov multiplier is 5, an increase in G causes Y to increase by 5 times as much.

Question 17

Tax multiplier.

Answer 17

Shows how much income changes in response to a change in tax

Change in Y / Change in T = -MPC/1-MPC

E.G if tax multiplier is -4, for a £1 decrease in tax, £4 extra income is gained

Question 18

Example of planned vs actual expenditure

Answer 18

Pandemic-
Actual>planned,so inventories increased.

Firms reduce production, laying off workers