The IS LM Model Part 2

Question 1

Why can’t we use Loanable funds model to capture the money market for KEYNESIAN

Answer 1

Because the LFM is for classical, where we assume market clearing (prices are flexible)

We need sticky prices in the short run

Question 2

What is the Keynesian money market called

Answer 2

Market for real money balances

Question 3

The Theory of liquidity preference applies to the market for real money balances just like the LFM model, what is it?

Answer 3

IR is determined by supply and demand for money

Question 4

What do we define money supply (m) as, and why

Answer 4

M/P

Economists argue the nominal value of M doesn’t matter, but how many g&s can be bought with the money

Similar to value of money, but M/P shows value of all money, rather than one unit 1/P

Question 5

Supply of real money balances diagram and axis and why it looks like that

Answer 5

Real interest rate (r) y axis
Real money balances, (m/p) x axis

Vertical straight line. This is because M/P is independent of interest rate. M is exogenous, and P is fixed as well as sticky prices exist in Keynesian.

Question 6

Where does demand for real money balances come from and why it is different from classical assumptions

Answer 6

Desire to hold money in a spendable form

In classical models, money demand depends on level of prices (higher prices, demand more money) due to market clearing.

Now prices are fixed with Keynesian, what would demand for money actually depend on?

Question 7

So what does demand for real money balances come from, and why?? (not influenced by prices as in Classical anymore, due to sticky prices)

Answer 7

Real interest rate

Interest rate show opportunity cost of holding money in pocket.

If interest rate is high, less money is demanded as higher opportunity cost of holding money (could be earning even more interest)

Therefore interest rate and money demand have an inverse relationship

So in Keynesian, demand for money is dependent on interest rates, rather than price (classical)

Question 8

What does the diagram for demand for real money balances look like axis, and labels

Answer 8

Downward sloping denoted L(r). As when interest rate low, demand is high as opportunity cost of holding cash is less

Real interest rate on y axis
RMB, M/P on x axis

Question 9

What else impacts demand for RMB

Answer 9

Income, more income=more money you will demand

Positive relationship between income and demand for RMB.

Therefore L(r,Y)

Question 10

What would a rise in national income look like on the money market model

Answer 10

An outward shift in demand for money caused by the income increase (more income=demand for spendable funds)

Question 11

How do we find the equilibrium interest rate

Answer 11

Where MS (M/P) = MD (L(r,y))

Question 12

What is RMB model good for

Answer 12

Monetary policy changes

Question 13

What is ISLM model and is it short or long run and why

Answer 13

Investment-saving Liquid-money model

Short run model-as prices are sticky

Question 14

What does IS curve show, and what is it derived from?

Answer 14

All combinations of real interest rate and output that result in goods market equilbrium

Derived from Keynesian cross (planned expenditure (AD) =actual output)

Question 15

What is equation for IS curve

Answer 15

Y=C+I+G (same as Keynesian cross)

Question 16

What does planned investment depend on? (part of planned expenditure as E=C+I+G)

And as a part of planned expenditure, what would an increase in r do to the diagram?

Answer 16

Real interest rate (r)

A rise=investment falls, so planned expenditure E would shift down
A decrease=investment increase, vice versa

Question 17

A)As planned investment is a part of planned expenditure, what would an increase in r do to the Keynesian cross diagram?

B)And how would it be show on on a IS curve, with axis’

Answer 17

E WILL SHIFT DOWNWARDS AS PLANNED INVESTMENT IS PART OF PLANNED EXPENDITURE (AE=C+I+G)

B) Downward sloping curve, r on y axis, Y on x axis
No shift, just a contraction on IS curve, thus pushing interest rate up and Y falling

Question 18

What does the LM curve show, and what is it derived from?

Answer 18

All combinations of r and Y that result in money market equilibrium

Derived from the money market=market for real money balances

Question 19

LM curve equation

Answer 19

M/P=L(r,Y)

Question 20

How is LM curve shown

Answer 20

Upward sloping, as when income increases, the interest rate rises, and Y increases (as when we’re richer we demand more money in a spendable form)

Question 21

IS summary of why downward sloping

Answer 21

Higher interest rate=decreased investment.
Decreases planned expenditure (shift down) . So output must fall to stop inventories accumulating (Y1>Y2)

So an increase in r is linked to a decrease in Y shown in LM too.

Important:investment (via r) plays a key role in the derivation of IS curve. E.g high r=contraction of IS (fall in Y)

Question 22

Summary of LM curve positively sloped

Answer 22

Increase in income, increases demand for money which increases interest rate.

Thus an increase in Y leads to increase in R, thus a positive relationship and slope.

Question 23

So what determines movements along LM and IS (IMPORTANT TO REMEMBER)

Answer 23

IS-investment (via interest rate)
LM-Income and interest rate

Question 24

Expansionary fiscal policy on IS-LM e.g gov spending

Answer 24

Increase in G= increase in planned expenditure (as part of E=C+I+G in Keynesian cross)

The Keynesian cross shows This creates higher level of Y at the given r. Thus causing an outward shift in the IS curve. The difference between original and new Y at the same interest rate is the government purchases multiplier!

We then need to find new equilbrium so LM also extends and we end up at a higher R too. This shows the crowding out effect, dampening the GPM as government cause the higher R, hence contracting the new IS2.

R can also increase because of demand for money increasing following the higher Y (income) which explains the LM extension.

(Y has still increased but is just dampened by crowding out)

Question 25

What does a change in G or C cause? IMPORTANT

Answer 25

A shift in IS (fc 24 to see why)

Question 26

What does a change in I(R) cause

Answer 26

Movement along IS curve

As we saw in card 24, crowding out (from increased G) increased the interest rate, contracting IS to the higher r.

Question 27

Expansionary monetary policy on ISLM

Answer 27

Increase in money supply=increases supply of RMB.
Creates lower r for given Y. ( IN THE LM CURVE DIAGRAM), causes rightward shift in LM curve to LM2

Low r=higher I in Keynesian cross so translates to higher Y and movement along IS! This explains the movement along IS where overall there has been a increase in Y and fall in R.

Meanwhile, LM2 extends as lower interest rate increases demand for money as lower opportunity cost of holding, thus causing extension, or rise in income increases demand for money

Question 28

What does a change in M or P do to LM curve
And what does a change in Y do to LM curve

Answer 28

A change in M/P causes a shift in LM, as M/P makes up the money supply formula.

A change in Y (via money demand) causes a movement along LM

Question 29

What do Keynesians say (3)

Answer 29

Gov should intervene, as economy does not adjust itself in short run.

Fiscal policy is key, monetary policy is complementary

Prices do not change in short run so inflation is not an issue.

Question 30

RMB model supply and demand

Answer 30

Supply=Money supply (M/P)

Demand=Money demand L (r,Y)

Question 31

IS movements and shifts

LM movements and shifts

Answer 31

IS Movements- changes in I(r)
IS Shifts-Changes in C and G

LM Movements-changes in income/interest rate which ultimately influence money demand
LM shifts-changes in M/P

Question 32

Note: for expansionary policies, e.g the gov spending shifts e in Keynesian cross, ALWAYS CREATES AN INCREASE IN Y AT A GIVEN R.

Monetary policy, creates a shift in money supply (M/P), CAUSING A FALL IN R AT A GIVEN Y

The derived diagrams always have a shift. But is translated into a movement along given curve

Question 33

The Great Recession 2008 responses

Answer 33

Fiscal:
Reduced VAT (17.5% to 15%)

Monetary:
QE (£1.5tn)