Topic 3 - IS/LM Flashcards
What are the 3 ways in expressing the equilibrium? (Keynesian Cross)
- Output = AD
Y= C+I+G - Output = National Income
C+S+T= Y = C+I+G
(Suggests National Income equals to Output which equals to AD)
3.Output = National Product
C+ Ir + G = Y = C+I+G
Hence, Ir = I
(Where I is desired investment and Ir is actual investment)
How do we determine Equilibrium according to the Keynesian Cross?
SEE NOTES
How do you derive the equilibrium mathematically?
SEE NOTES
What is the First Application (Mario Draghi’s speech) discussing?
Brings forth 2 key aspects about the ECB nowadays
- Uncertainty
- Monetary Stimulus
EXAMPLE OF PRACTICAL APPLICATION OF FINDING OUT THE MULTIPLIER
SEE IN NOTES
What is the IS Curve?
Shows all those combinations of GDP and interest rate for which aggregate desired spending equals actual output
How do we derive the IS Curve?
SEE IN NOTES
What are the factors affecting the slope of the IS Curve?
SEE GRAPH IN NOTES
- Sensitivity of Investment
- When have steep investment schedule have steep IS Curve
- Flat investment schedule have flat IS Curve
- When investment goes up need increase in investment to balance to do via increase in income
What is the derivation of the IS Curve (with Govt)?
SEE GRAPH IN NOTES
What causes shifts in the IS Schedule?
- Change in any autonomous function
- The graphs in the slides display this
How do you derive IS schedule mathematically
See in notes
What is the Liquidity Preference?
Keyne’s term for the demand for money relative to bonds
Wh = B + M Where: Wh = Wealth B = Bonds M = Money Assets
What are the 2 ways presenting the equilibrium for the LM Curve?
Walras Law:
Equilibrium in one market implies equilibrium in another
so we just look at one. We look at only one in the money market
What are the 3 types of Money Demand/Motives?
- Transaction Demand
Positive related to Income
In holding money there is an opportunity cost of Interest - Precautionary Demand
- Speculative Demand
Describes the desire to have money for the purpose of investing in assets
How do you calculate wealth with the differing money demands?
Mi = Mi 1 + Mi 2
(Transaction Demand + Speculative Demand)
Wh i = Mi +Bi
How do you calculate Total Demand for Money?
Md = L(Y,R) L = Liquidity Y = Income R = Interest
Md = C0 +C1Y -C2R
C1Y - How does Money demand change income rises
C2R- Relationship between money demand and interest
How do you derive Money Supply mathematically?
MS0 = C0 +C1Y C2R
C1Y - How does Money demand change income rises
C2R- Relationship between money demand and interest
How do you derive LM Mathematically?
LM:
r = C0/C2 - MS0/C2 +C1/C2 Y
SEE NOTES FOR BETTER VIEW
What are the factors that determine the slope of the LM Curve?
- C1: By how much money demand changes by income
2. C2: Money demand changes by interest (Interest Elasticity)
What causes shifts in the LM Curve?
- Changes in money supply (HOLDING INCOME CONSTANT)
- Interest rate change in Money Demand (HOLDING INCOME CONSTANT)
SEE GRAPHS IN NOTES
What are the 2 extreme cases of LM Derivation?
- C2 = 0 (No interest - Not responsive at all)
2. C2 reaching infinity
What does the IS/LM Curve look like?
SEE GRAPH IN NOTES
What does the IS/LM Curve represent?
- Equilibrium in the Bond Market
- Equilibrium in the Money Market
- Equilibrium in the Goods Market
How do we derive the IS/LM Equilibrium mathematically?
SEE IN NOTES
How do we derive the Fiscal and Monetary Multipliers?
SEE IN NOTES
How can we adapt the IS-LM Model to the application of the US Recession in 2001? (Causes)
- Dot com bubble
Causes:
The decline in the stock market,
The September 11 terrorist attacks on New York and Washington,
A number of accounting scandals at prominent corporations
Initially shifting the IS Curve to the left
How can we adapt the IS-LM Model to the application of the US Recession in 2001? (Response)
- The Fed adopted an expansionary monetary policy
- Congress passed a tax cut, including an immediate rebate, and also passed an emergency spending measure to help rebuild New York and bail out the airline industry.
Causing the IS Curve to shift to the left
Causing the LM Curve to shift to the left as increased money demand
How can we apply the IS-LM Model to the Great Depression?
We can see
-Unemployment decreased
- Real GNP decreased
(Leading to a shift left for the IS Curve)
- Money Supply decreased
- Price Level decreased
(Leading to a shift left in the LM Curve)
So, was the depression caused by an IS shock or an LM Shock?
What is the Spending Hypothesis (Shocks to the IS Curve)?
-Asserts the Depression was largely due to an exogenous fall in the demand for goods and services—a leftward shift of the IS curve.
Evidence:Output and interest rates both fell, which is what a leftward IS shift would cause.
Stock market crash reduced consumption
Oct 1929–Dec 1929: S&P 500 fell 17%
Oct 1929–Dec 1933: S&P 500 fell 71%
Drop in investment
- Correction after overbuilding in the 1920s.
- Widespread bank failures made it harder to obtain financing for investment.
-Contractionary fiscal policy
Keynes argued the Govt of the time more focused on balancing the budget than helping the economy
What is the Money Hypothesis? (Shock to the LM Curve)
Asserts that the Depression was largely due to the huge fall in the money supply.
Evidence: M1 fell 25% during 1929–1933.
What are the two problems with the money hypothesis?
P fell even more, so M/P (Real Money balances: What money can actually buy) actually rose slightly during 1929–1931.
Nominal interest rates fell, which is the opposite of what a leftward LM shift would cause.
What is the response of the Money Hypothesis to the critiques of this theory?
Asserts that the severity of the Depression was due to a huge deflation:
P fell 25% during 1929–1933.
This deflation was probably caused by the fall in M, so perhaps money played an important role after all.
What is the effects of falling prices? (Money Hypothesis)
Deflation has a stabilising effect
Decrease in P = Increase in M/P = LM shifting to the right = Increase in Y
The Pigou Effect also explains this as: Decrease in P = Increase in M/P - Consumers wealth goes up - Consumption increases - IS shifts to the right - Y increases
What are the destabilising effects of EXPECTED deflation? (Money Hypothesis)
Decrease in Eπ (Expected Inflation) leads to:
- Increase in R for each value of i
- I because I = I (R)
- Planned expenditure and agg demand decrease
- Income and Output decrease
What are the destabilising effects of UNEXPECTED deflation?
Debt Deflation Theory:
A decrease in P (if unexpected) leads to:
- transfers purchasing power from borrowers to lenders
- Borrowers spend less, lenders spend more
- If borrowers’ propensity to spend is larger than lenders’, then aggregate spending falls, the IS curve shifts left, and Y falls
What is the Debt Deflation Theory?
That recessions and depressions are due to the overall level of debt rising in real value because of deflation,
This is due to money supply being tightened, there is an increase in the value of money, which increases the real value of debt.
This makes it harder for borrowers to pay their debts.
Since money is valued more highly during deflationary periods, borrowers are actually paying more because the debt payments remain unchanged.
Why is another Depression unlikely?
- Policymakers (or their advisers) now know much more about macroeconomics:
- The Fed knows better than to let M fall so much, especially during a contraction.
-Fiscal policymakers know better than to raise taxes or cut spending during a contraction.
Federal deposit insurance makes widespread bank failures very unlikely.
Automatic stabilisers make fiscal policy expansionary during an economic downturn
How do expectations affect Consumption?
- Directly via human wealth (After-tax labour income over working life)
- Indirectly via non-human wealth (Sum of financial wealth/Investing and Housing wealth)
What are the implications of expectations of the relations between consumption and income?
- Consumption likely to respond to less than 1 for 1 in current income (If change in income `by 1 unit expect change in consumption by less than 1 unit due to consumption smoothing)
- Consumption may move even if current income doesn’t change
How do expectations impact investment?
Investment is a function of future profits. Therefore, future productivity/ interest rate impacts current investment. Expectations affect investment
What happens to the IS Curve when we consider expectations?
Becomes much steeper
What is the reason for the IS Curve becoming steeper when considering expectations?
- Depends on changes in interest and how that affects spending given a level of income
- Size of multiplier
What is an example of the IS Curve becoming steeper?
- Decrease in current real policy rate (interest rate) given unchanged expectations of future real policy rate, doesn’t have much effect on private spending (Don’t see change in future)
- Multiplier likely to be small cus of change in current income, given unchanged expectations of future income, is unlikely to have large effect on spending
- Given expectations, decrease in real policy rate leads to small increase in output. The IS Curve steeply downward sloping
What shift the IS Curve to the right (considering expectations)?
- Increases in Govt spending or in expected future output
What shifts the IS Curve to the left (Considering Expectations)?
- Increase in taxes,
- Increase in expected future taxes or in expected future policy rate
What are the effects on monetary policy (considering expectations)?
- If monetary expansion leads to changes in expectations of future interest rates and output then policy effect on output may be large (ADDITIONAL SHIFT IN IS CURVE)
- But if expectations remain unchanged, the policy effects on output will be limited
What are Rational Expectations?
Expectations formed in forward-looking manner
What did Keynes refer to Rational Expectations as?
Animal Spirits
- people and businesses invested based on how they felt
What other forms of expectations did Economists come to find?
- Static Expectations
- Adaptive Expectations
What are Static Expectations?
People expect future to be like the present
What are Adaptive Expectations?
People ‘adapt’ by revising expectations over time
What is Lucas’s and Fargent’s theory on rational expectations?
People have rational expectations as they look into future and try predict best they can
What are the Impacts in reducing the deficit (Fiscal Policy)? (Considering Expectations)
In attempt to move to more balanced budget:
G decreases, T increases
Assuming expectations
When taking into account expectations, G decreasing doesn’t have to amount to output decreasing too
In SR fall in output due to Govt spending decrease to reduce deficit
In mid term (expectation of interest to fall) can lead to interest decrease and output rising (CROWDING IN)
In mid term (Expectation of taxes to fall) lead to taxes decrease and output increase
What does the Net effect of the 3 shifts in the IS Curve depend on? (PART 1)
Considering deficit reduction, expectations and output
- Timing
- Must be backloading the deficit reduction program toward the future with small cuts today and larger cuts in future,more likely to lead to increase in output
(Expect that Govt spending larger cut in the future so T increase so people spend more in current period)
- Programmes credibility (perceived probability that Govt will do what it has promised when time comes)
(If don’t stick to the plan. the effect you trying to receive get minimised)
- Composition of Deficit Change
- If some Govt programmes seen as ‘wasteful’ cutting them today will allow govt to cut taxes in future
- Expectations of lower future taxes and lower distortions could induce firms to invest today thus raising output in SR
What does the Net effect of the 3 shifts in the IS Curve depend on? (PART 2)
- Initial Situation of Economy
- If debt increasing fast, then credible deficit reduction programme more likely to increase output in SR since programme announcement may reassure people that Govt has regained control of budget - Monetary Policy
- Even if monetary policy cannot fall, offset the effect of adverse shift of IS Curve, decrease in policy rate (interest rate) can help reduce adverse effects of shift on output
What are the 2 ways we derive AD?
Via the quantity theory of money
Via IS/LM
How do we derive AD via IS/LM?
SEE GRAPH IN NOTES
What are the impact of Monetary Policy on the AD Curve?
If FED increase AD
- Increase money supply
- Causes LM shifting right (Real money balances up)
- Causes Interest rate to decrease
- Causes Investment to increase
- Causes an increase in Y at each value of P
SEE DIAGRAM IN NOTES
What are the impacts of Fiscal Policy on the AD Curve?
- Expansionary Fiscal Policy (Increase in G and/or Decrease in T)
- Increases AD
Decrease in T leads to C up - IS shifts right
- Increase in Y for each value of P
SEE DIAGRAM IN NOTES
