Week 6 Lecture 1 Flashcards
Explain what the IS-LM model is used for
- The IS-LM describes short-run equilibrium in the goods market and the money market
- It determines the interest rate (i) and income (Y)
What does the Investment-Saving curve (IS) show?
- The IS curve shows the relationship between the interest rate and income that ensures equilibrium in the goods market
- It also shows equilibrium for different levels of interest
What does the Liquidity-Money (LM) curve show?
- The LM curve shows the relationship between the interest rate and income representing equilibrium in the money market
- It also shows the interest rate that clears the money market for each level of income
What is the main key assumption of the IS-LM model?
- The key assumption of the IS-LM model is that the general price level (P) of the economy is constant
- This implies that only quantities and the rate of interest can vary to clear the markets, not prices
How would we re-interpret the national account identity as per the Keynesian cross?
The national account identity is as follows: Y = C + I + G + NX
- Y is actual production or national income. We can think of this as what is actually produced and firms want to sell
- C + I + G + NX is planned expenditure or spending. This can be thought of as what people are actually going to buy
When does equilibrium occur in relation to the Keynesian cross re-interpreted version of the national account identity?
Equilibrium occurs when actual production is equal to planned expenditure
What does planned expenditure depend on?
Planned expenditure depends on the interest rate
What two components of planned expenditure does does the interest rate (i) directly influence?
The interest rate directly influences Consumption (C) and Investment (I)
Explain how the interest rate (i) influences Consumption (C)
- Households spending decisions depend on interest rate levels
- Higher interest rates mean higher returns on savings, hence households save more and consume less
How does the interest rate (i) influence Investment (I)?
- Firms investment decisions are based on borrowing costs (interest rate)
- Higher interest rates imply that there are higher borrowing costs hence firms will drop less profitable investments so investment drops at high interest rates
What type of relationship does the Investment-Savings curve show?
The IS curve shows a negative relationship between the interest rate (i) and national income/production (Y)
Draw both a Keynesian cross and the IS curve diagram to show the IS curve can be derived from the Keynesian cross
See slide 10 of Week 6 Lecture 1
What is money supply assumed to be?
Money supply is assumed to be constant (exogenous)
Draw a general Liquidity-Money curve (LM) and which way does it slope
- The LM curve slopes upwards due to the positive relationship between the interest rate (i) and income (Y)
- See slide 12 of Week 6 Lecture 1
What does the equilibrium point of a IS-LM diagram tell us?
The equilibrium point shows the level of the interest rate and income such that both markets are in equilibrium at the same time
Draw a general IS-LM model diagram and label the equilibrium point
See slide 13 of Week 6 Lecture 1
What does the aggregate demand (AD) curve show?
The AD curve shows the relationship between the general/aggregate price level and national income/output
Explain how the AD curve can be derived from the IS-LM model
- The IS-LM model gives us the equilibrium level of interest rate and income for a given price level (P0)
- Consider another price level (P1), higher than the original price level (P0)
- Real money supply has now decreased due to the higher price level
- This shifts the LM curve to the left (due to Money supply also shifting left)
- The economy transitions to a new equilibrium with higher interest rates and lower income/production
- This corresponds to two different points on the AD curve (higher price level is associated to a lower level of output)
