Topic 8 Flashcards
What is the Keynesian cross model?
A closed economy model where income is determined by expenditure
See
Top of page 1 notation and diagram
How would an increase in G spending affect the KC diagram?
Shifts PE upwards
Increase G -> fall in unplanned inventories -> increase output tf Y increases too
Define government purchases multiplier?
The increase in income resulting from a £1 increase in G
How would an increase in T spending affect the KC diagram?
See notes
Prove the Gov PM and Tax PM equations
Now (see slides)
3 points about the tax multiplier?
…is negative:
A tax increase reduces C, which reduces income.
…is greater than one (in absolute value):
A change in taxes has a multiplier effect on income.
…is smaller than the govt spending multiplier:
Consumers save the fraction (1–MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G.
Define tax multiplier?
The change in income resulting from a £1 increase in T
What does the IS curve show?
All the combinations of r and Y that result in goods market equilibrium
Derive the IS curve
Now - see notes
Why is the IS curve negatively sloped?
Because a fall in r -> increase in investment spending -> increase planned expenditure
What is the theory of liquidity preference?
A theory in which the interest rate is determined by money supply and money demand
See
Slides: how FP affects the IS curve
Draw supply and demand of RMB curve?
Now: see notes
How does the CB change r?
The supply of RMB is fixed, so the interest rate adjusts to equate the supply and demand for money; by changing the money supply they affect money demand and tf the real interest rate
What is the LM curve?
A graph of all combinations of r and Y that equate supply and demand for RMB
Derive the graph for the LM curve
Now (see notes)
Why is the LM curve UWS?
Increase in Y -> increase money demand -> increase in r (since supply of RMB is fixed)
Explain how a change in the money supply would affect the LM diagram?
It’d shift supply of RMB left, tf causing the LM curve to shift up
Draw SREQ of IS-LM diagram
Now (see notes)
See
top of page 2 notes recap bit
Explain how an increase in government purchases would affect the IS-LM diagram?
IS shifts right by (1/(1-MPC)).ΔG
Tf increase in Y -> increase in money demand -> increase r -> decrease in investment
TF overall increase in Y is less than (1/(1-MPC)).ΔG (see diagram)
Explain how a decrease in tax would affect the IS-LM diagram?
Consumers save (1-MPC) of the tax cut tf initial spending boost is less for ΔT than an equal ΔG
IS curve shifts right by (-MPC/(1-MPC))ΔT (see diagram)
Explain how an increase in money supply would affect the IS-LM diagram?
Downward shift of LM curve -> decrease in r -> increase in investment and increase in Y
3 possible responses the CB may use to an increase in government spending and their explanations? Draw their diagrams.
1) Hold M constant:
LM doesn’t shift, Y and r increase
2) Hold r constant:
Increase in G -> increase in IS curve. To keep r the same, CB increase M tf LM shifts down tf Y increases further and Δr=0
3) Hold Y constant:
Increase in G -> increase in IS curve. To keep Y constant CB decrease the money supply tf left shift of LM curve, tf ΔY=0, r raises further
What causes the IS curve to shift?
Exogenous changes in the demand for goods and services (shocks):
eg. change in consumer confidence
stock market boom/crash
What causes the LM curve to shift?
Exogenous changes in the demand for money:
eg. -credit card fraud -> increase demand for money
- internet shopping reduces demand for money
Use the IS-LM model to analyze the effects of
1. a housing market crash that reduces consumers’ wealth
2. consumers using cash in transactions more frequently in response to
an increase in identity theft
do it
Explain how the FED controls interest rates?
They set a target for the federal funds rate, which is the interest rate banks charge each other on overnight loans. They then change the money supply accordingly to shift the LM curve to achieve their target. Other short term rates then typically move with the federal funds rate.
Derive the AD curve using the LM curve? Explain the intuition behind it.
See slide 20
Increase in P -> decrease in (M/P) -> LM curve shifts left -> increase in real interest rate -> fall in investment and tf a fall in Y
Tf increase in P -> decrease in Y tf DWS AD
How can the FED increase aggregate demand?
By increasing money supply, they shift LM curve right -> fall in r -> increase in I -> increase in Y AT EACH LEVEL OF P tf AD has shifted right
Explain how expansionary fiscal policy will affect the IS-LM model?
Inc. G or dec. T:
-> inc. C -> IS shifts right -> inc. Y and r
Explain, with diagrams, the SR and LR effects of an IS shock?
See slides 24-28
also do slides 29-30
What is the spending hypothesis?
Hypothesis that the US depression was largely due to an exogenous fall in demand for goods and services; a leftward shift of the IS curve. The evidence for this is that output and interest rates both fell, which is what a leftward shift of the IS curve would cause
In the spending hypothesis, explain the 3 causes of the IS curve shift?
1) Stock market crash reduced consumption:
- Oct 1929–Dec 1929: S&P 500 fell 17%
- Oct 1929–Dec 1933: S&P 500 fell 71%
2) Drop in investment:
- Correction for overbuilding in the 1920s
- Widespread bank failures made it difficult to attain finance
3) Contractionary fiscal policy:
Politicians raised taxes and cut spending to reduce increasing deficits
What is the money hypothesis and evidence?
Hypothesis that the depression was largely due to a huge fall in the money supply tf shifting LM curve left. Evidence is that M1 fell 25% from 1929-1933
Explain 2 issues with the money hypothesis?
1) P fell further than M in this period so M/P technically rose a bit
2) Nominal interest rates fell, which is the opposite of what a leftward shift of the LM curve would cause
Explain the improved money hypothesis?
Money supply falling might’ve led to a fall in the price level, tf deflation
What are the 4 possible effects of deflation?
- The stabilizing effects of deflation
- The Pigou effect
- The destabilizing effects of expected deflation
- The destabilizing effects of unexpected deflation
Explain the stabilizing effects of deflation?
Decrease P -> Increase M/P -> LM shifts right -> inc. Y
Explain the Pigou effect?
Decrease P -> increase M/P -> increase consumer wealth -> increase C -> IS curve shifts right -> increase in Y
Explain the destabilizing effects of expected deflation?
Decrease expected inflation -> increase in r for each value of i -> decrease investment -> fall in AD -> fall in Y
Explain the destabilizing effects of expected deflation?
Debt deflation theory:
Decrease in P unexpectedly -> transfer of purchasing power from borrowers to lenders -> lenders spend more, borrowers spend less
tf if borrowers have a higher propensity to spend than lenders, then aggregate spending falls
Tf IS shifts left, Y falls
4 reasons another depression is 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.
ALSO:
-Federal deposit insurance makes widespread bank failures very unlikely.
-Automatic stabilizers make fiscal policy expansionary during an economic
downturn
