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ES10002- Introduction to Macroeconomics > Topic 6 Part 2 > Flashcards

Topic 6 Part 2 Flashcards

1
Q

How do you show the production function if the economy is at the full employment output level?

A

Ybar = AF(K, Nbar)

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2
Q

What is the full-employment curve labelled as?

A

FE

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3
Q

What is the full-employment level?

A

The level of output when the labour market is in equilibrium

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4
Q

If plotted against real interest rates and output, what does the FE line look like and why?

A

We get a vertical line, since the
labor market equilibrium is unaffected by changes in the real interest rate

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5
Q

What shifts the full-employment line to the right?

A

✓A beneficial supply shock (which raises MPN and thus labour demand)
✓An increase in labour demand
✓An increase in labor supply
✓An increase in the capital stock

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6
Q

When is the goods market in equilibrium?

A

Aggregate demand = Aggregate supply

Yad=Y or S^d=I^d

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7
Q

What adjusts to bring the goods market into equilibrium?

A

The real interest rate

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8
Q

What does the IS curve show?

A

The IS curve shows the real interest rate r for which the goods market is in equilibrium

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9
Q

What is special about all the points on the IS curve?

A

All the points are where Yad = Y. (All show a good market in equilibrium).

All points also show when the loanable funds market is in equilibrium.

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10
Q

What does the IS curve look like?

A

Downwards sloping

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11
Q

How do you derive the IS curve?

A

Look at slides

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12
Q

What happens to IS when for a given level of output, any change that reduces desired national saving relative to desired investment?
Why and what happens in the market?

A

IS curve shifts to the right.

Intuitively, imagine constant output, so a reduction in saving means more investment relative to saving. There is an excess demand for loanable funds which leads the real interest rate to rise. The increase in r reduces investment and increases saving, thus it brings the loanable funds market in equilibrium.

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13
Q

Assuming that the real interest rate is constant, a change that increases the aggregate demand for goods does what to equilibrium and the IS curve?

A

Creates an excess demand for goods in the goods market. At the same real interest rate output (supply, 𝑌) must rise to restore equilibrium. Thus, the IS curve shifts to the right.

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14
Q

What are the factors that shift the IS curve to the right?

A
  • an increase in expected future output (↓ 𝑆^𝑑)
  • an increase in wealth (↓ 𝑆^𝑑)
  • a temporary increase in government purchases (↓ 𝑆^𝑑)
  • a decline in taxes, if Ricardian equivalence doesn’t hold (↓ 𝑆^𝑑)
  • an increase in the expected future marginal product of capital (↑ 𝐼^𝑑)
  • a decrease in the effective tax rate on capital (↑ 𝐼^𝑑)
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15
Q

What is the real money supply not affected by?

A

Real interest rates

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16
Q

How does an increase in expected future output shift the IS curve to the right?

A

Desired saving falls (desired
consumption rises), raising
the real interest rate that
clears the goods market

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17
Q

How does an increase in wealth shift the IS curve to the right?

A

Desired saving falls (desired
consumption rises), raising
the real interest rate that
clears the goods market

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18
Q

How does an increase in government purchases shift IS curve to the right?

A

Desired saving falls (demand
for goods rises), raising the
real interest rate that clears
the goods market

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19
Q

Why does an increase in taxes wither cause no change in the IS curve or shift it to the left?

A

No change if consumers take
into account an offsetting
future tax cut and do not
change consumption (Ricardian equivalence).

To the left if consumers don’t take into
account a future tax cut and reduce desired consumption, increasing
desired national saving and lowering the real interest that clears the goods market.

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20
Q

How does an increase in expected future marginal product of capital shift the IS curve to the right?

A

Desired investment
increases, raising the real
interest rate that clears the
goods market

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21
Q

How does an increase in the effective tax rate on capital shift the IS curve to the left?

A

Desired investment falls,
lowering the real interest
rate that clears the goods
market

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22
Q

What does the real money supply not being affected by real interests mean?

A

𝑀^𝑠/𝑃 =𝑀bar/𝑃

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23
Q

When does real money demand rise and fall?

A

Real money demand falls as the real interest rate rises and rises as the level of output rises

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24
Q

What is the equation for real money demand?

A

𝑀^𝑑/𝑃= 𝐿(𝑌, 𝑟)

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25
Q

When is equilibrium in the money market met?

A

𝑀bar/𝑃 = 𝐿(𝑌, 𝑟)

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26
Q

How is the LM curve derived?

A

Derived by plotting real money demand for different levels of output and looking at the resulting equilibrium

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27
Q

At a given output level Y, what does the LM curve show?

A

The real interest rate for which the money market is in equilibrium

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28
Q

Why is the LM curve downwards sloping?

A

Starting at equilibrium, suppose output rises, so real money demand increases.
The rise in people’s demand for money makes them sell nonmonetary assets, so the price of those assets falls, and the nominal and real interest rates rise.
As the interest rate rises, the demand for money declines until equilibrium is reached

29
Q

What are the factors that shift the LM curve up- money supply?

A

Any change that reduces real money supply (↓𝑀bar/𝑃) relative to real money demand 𝐿(𝑌, 𝑟) shifts the LM curve up.

30
Q

What shifts the LM curve downwards- money supply?

A

Any change that increases real money supply (↑𝑀bar/𝑃) relative to real money demand 𝐿(𝑌, 𝑟) shifts the LM curve downwards.

31
Q

What shifts the LM curve up- money demand?

A

Any change that increases real money demand ↑ 𝐿(𝑌, 𝑟) relative to real money supply (𝑀bar/𝑃) shifts the LM curve up.

“Any change”: Any factor that affects nominal and real money demand except a change in output Y.

32
Q

What does a change in output Y cause for the LM curve?

A

A movement along, not a shift

33
Q

Outline the factors that shift the LM curve

A

Change in Nominal money supply.
Change in Price level.
Change in Expected inflation.
Change in Nominal interest rate on
money.
Change in wealth.
Change in relative risk of alternative assets relative to the risk of holding money.
Change in liquidity of alternative assets.
A change in the efficiency of payment technologies.

34
Q

How does an increase in nominal money supply effect the LM curve?

A

Shifts it to the right- Real money supply increases, lowering the real interest
rate that clears the money
market

35
Q

How does an increase in the price level effect the LM curve?

A

Shifts it to the left- Real money supply falls, raising the equilibrium real
interest rate

36
Q

How does an increase in expected inflation effect the LM curve?

A

Shifts it to the right- Demand for money falls, lowering the equilibrium real
interest rate

37
Q

How does an increase in the nominal interest rate on money effect the LM curve?

A

Shifts it to the left- Demand for money
increases, raising the equilibrium real interest rate

38
Q

What is general equilibrium?

A

Equilibrium when all markets are simultaneously in equilibrium

39
Q

When does general equilibrium occur?

A

Occurs where the FE, IS, and LM curves intersect

40
Q

Explain how a temporary adverse supply shock effects general equilibrium.

A

Productive parameter in the production function falls temporarily.
Because its temporary, labour supply not affected.
Reduces the MPL, hence labour demand.
Equilibrium real wage and employment fall.
Lower productivity and employment reduce the equilibrium level of output, shifting the FE line to the right.
No direct effect of a temporary supply shock on the IS or LM curves.
However, as the price level rises the LM curve shifts up and to the left until a general equilibrium is reached.
Real interest rates rise and output declines.

41
Q

What happens to general equilibrium when the Central Bank increases the nominal money supply? (Holding prices constant to start with)

A

Real money supply increases.
Shifts LM curve to the right.
No point now where all three curves intersect.
Assume that the labor market is temporarily out of equilibrium, so there is a short-run equilibrium at the intersection of the IS and LM curves.
The increase in the money supply causes people to try to get rid of excess money balances by buying bonds, driving the real interest rate down.
Consumption and investment increase temporarily, due to fall in r.
Output is assumed to increase temporarily to meet the extra demand.
Since the demand for goods temporarily exceeds firms’ desired supply of goods, firms raise prices.
The rise in the price level causes the LM curve to shift up.
Price level continues to rise until the LM curve intersects with the FE line and the IS curve at general equilibrium.

42
Q

What is the long-run effects of a monetary expansion on equilibrium?

A

No change in employment, output, or the real interest rate.
Price level is higher by the same proportion as the increase in the money supply.
So all real variables are unchanged, while nominal values have risen.

43
Q

When the economy isn’t in general equilibrium what do we assume about the asset market and why?

A

Because financial markets respond most quickly to changes in economic conditions, the asset market responds to the disequilibrium

44
Q

When the economy isn’t in general equilibrium, what do we assume about the labour market?

A

The labor market (FE line) is slow to respond, because job matching, and wage renegotiation take
time

45
Q

When the economy isn’t in general equilibrium, what do we assume about the goods market?

A

The adjustment speed of the goods market (IS curve) is somewhere in the middle (somewhat slow).

46
Q

In what scenario would there be no change in the real money supply, and the LM curve doesn’t shift?

A

If both the money supply and price level rise by the same proportion

47
Q

What are the two key questions in the debate between classical and Keynesian approaches in terms of the IS-LM model?

A

How rapidly does the economy reach general equilibrium?
What are the effects of monetary policy on the economy?

48
Q

How is the economy self-correcting?

A

The economy is brought into general equilibrium by adjustment of the price level

49
Q

What do Classical economists believe the speed adjustment of the price level to be?

A

Rapid adjustment of the price level.
So, the economy returns quickly to full employment after a shock.
If firms change prices instead of output in response to a change in demand, the adjustment process is almost
immediate.

50
Q

What do Keynesian’s think about the speed adjustment of prices?

A

Slow adjustment of the price level.
It may be several years before prices and wages adjust fully.

51
Q

When not in general equilibrium, where do Keynesian’s believe output is at?

A

Output is determined by aggregate demand at the intersection of IS & LM curves, while the labor market is not in equilibrium.

52
Q

What is monetary neutrality?

A

An economic theory stating that changes in the money supply only affect nominal variables and not real variables.

53
Q

What is the classical view on monetary neutrality?

A

The Classical view is that a monetary expansion affects prices quickly with at most a transitory effect on real
variables.
Classicals believe monetary neutrality holds even in the relatively short run.

54
Q

What is the Keynesian view on monetary neutrality?

A

Keynesians think the economy may spend a long time in disequilibrium, so a monetary expansion increases
output and employment and causes the real interest rate to fall.
Keynesians believe in monetary neutrality in the long run but not the short run,

55
Q

What does the aggregate demand curve show?

A

Shows the relationship between the quantity of goods demanded and the price level when the goods and asset markets are in equilibrium.

56
Q

What does the aggregate demand curve show in terms of IS-LM model?

A

The AD curve represents the price level and level of output at which the IS and LM curves intersect

57
Q

Why does the AD curve slope downwards?

A

Slopes downward because a higher price level is associated with lower real money supply, shifting the LM curve up, raising the real interest rate, and decreasing output demanded

58
Q

What does aggregate demand equal?

A

Yad = C^d + I^d + G

59
Q

How is the AD curve derived?

A

Look at slides

60
Q

What are factors that shift the AD curve?

A

Any factor that causes the intersection of the IS and LM curves to shift.
Any factor except a change in the P level.

61
Q

What does the aggregate supply curve show?

A

Shows the relationship between the price level and the aggregate amount of output
that firms supply

62
Q

Why is SRAS horizontal?

A

In the short run prices remain fixed, so firms supply whatever output is demanded.

63
Q

Why is the LRAS curve a vertical line?

A

Full-employment output is NOT affected by the price level

64
Q

When does SRAS curve shift?

A

Shifts whenever firms change their prices in the short run

65
Q

What shifts the LRAS curve?

A

Anything that changes full-employment output

66
Q

What is short term equilibrium?

A

AD intersects SRAS

67
Q

What is long run equilibrium?

A

AD intersects LRAS

AD, LRAS, and SRAS all intersect at the same point

68
Q

What is long run equilibrium also called?

A

General equilibrium

69
Q

Explain how general equilibrium is met when there is an expansion in the money supply.

A

Shifts AD to the right.
In the SR, when the price level is fixed, equilibrium occurs where SRAS1=AD2.
Since output exceeds the full-employment output, over time firms raise prices and the short-run aggregate supply
curve shifts up to 𝑆𝑅𝐴𝑆2, restoring long-run equilibrium.

ES10002- Introduction to Macroeconomics (11 decks)

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