The IS LM Model Part 2 Flashcards
Why can’t we use Loanable funds model to capture the money market for KEYNESIAN
Because the LFM is for classical, where we assume market clearing (prices are flexible)
We need sticky prices in the short run
What is the Keynesian money market called
Market for real money balances
The Theory of liquidity preference applies to the market for real money balances just like the LFM model, what is it?
IR is determined by supply and demand for money
What do we define money supply (m) as, and why
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
Supply of real money balances diagram and axis and why it looks like that
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.
Where does demand for real money balances come from and why it is different from classical assumptions
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?
So what does demand for real money balances come from, and why?? (not influenced by prices as in Classical anymore, due to sticky prices)
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)
What does the diagram for demand for real money balances look like axis, and labels
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
What else impacts demand for RMB
Income, more income=more money you will demand
Positive relationship between income and demand for RMB.
Therefore L(r,Y)
What would a rise in national income look like on the money market model
An outward shift in demand for money caused by the income increase (more income=demand for spendable funds)
How do we find the equilibrium interest rate
Where MS (M/P) = MD (L(r,y))
What is RMB model good for
Monetary policy changes
What is ISLM model and is it short or long run and why
Investment-saving Liquid-money model
Short run model-as prices are sticky
What does IS curve show, and what is it derived from?
All combinations of real interest rate and output that result in goods market equilbrium
Derived from Keynesian cross (planned expenditure (AD) =actual output)
What is equation for IS curve
Y=C+I+G (same as Keynesian cross)
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?
Real interest rate (r)
A rise=investment falls, so planned expenditure E would shift down
A decrease=investment increase, vice versa
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’
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
What does the LM curve show, and what is it derived from?
All combinations of r and Y that result in money market equilibrium
Derived from the money market=market for real money balances
LM curve equation
M/P=L(r,Y)
How is LM curve shown
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)
IS summary of why downward sloping
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)
Summary of LM curve positively sloped
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.
So what determines movements along LM and IS (IMPORTANT TO REMEMBER)
IS-investment (via interest rate)
LM-Income and interest rate
Expansionary fiscal policy on IS-LM e.g gov spending
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)
What does a change in G or C cause? IMPORTANT
A shift in IS (fc 24 to see why)
What does a change in I(R) cause
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.
Expansionary monetary policy on ISLM
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
What does a change in M or P do to LM curve
And what does a change in Y do to LM curve
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
What do Keynesians say (3)
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.
RMB model supply and demand
Supply=Money supply (M/P)
Demand=Money demand L (r,Y)
IS movements and shifts
LM movements and shifts
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
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
The Great Recession 2008 responses
Fiscal:
Reduced VAT (17.5% to 15%)
Monetary:
QE (£1.5tn)
