Week 8 - IS-LM & AD-AS

Question 1

What does income equal?

Answer 1

expenditure

Question 2

What do the RHS and LHS of Y = C + I + G + NX represent?

Answer 2

Right hand side ‘planned expenditure’

Left hand side ‘actual production’ (usually called national income)

Question 3

Deflationary gap

Answer 3

when C+I+G+NX could be less than full employment production, Y. At this level of demand, there is spare capacity and unemployment will rise.

Question 4

Inflationary gap

Answer 4

when C+I+G+NX is greater than full employment production, Y. At this level of demand, there is excess demand

Question 5

Investment Savings (IS)

Answer 5

Shows the points where the goods market is in equilibrium

Question 6

IS curve

Answer 6

a curve that shows all the possible combinations between interest rate and output (national income) in the goods market

Question 7

Why is the IS curve downward sloping?

Answer 7

because a rise in output increases national savings, which reduces the equilibrium real interest rate

Question 8

Liquidity Money (LM)

Answer 8

Shows the points where the money market is in equilibrium

Question 9

LM curve

Answer 9

the combinations of interest rates and levels of real income for which the money market is in equilibrium

Question 10

Why is the LM curve upward sloping?

Answer 10

because when output increases, the money demand increases, which raises the real interest rate in the economy.

Question 11

Why is the money demand curve downward sloping?

Answer 11

because of people’s liquidity preference. This means at lower interest rates people will wish to hold more cash-in-hand in anticipation of better investment prospects (higher returns/interest rates in the future)

Question 12

The IS-LM model

Answer 12

shows the relationship between the total output produced in the economy and the real interest rate

Question 13

What does the equilibrium point in the IS-LM model mean?

Answer 13

The equilibrium point shows the amount of output produced at the equilibrium real interest rate (planned expenditure = actual expenditure and money demand = money supply). The goods market equals the money market.

Question 14

What are three facts about economic fluctuations?

Answer 14

1. They are irregular and unpredictable
2. Most macroeconomic quantities fluctuate
3. As output falls, unemployment rises

Question 15

What are the features short run economic fluctuations?

Answer 15

• The assumption of monetary neutrality if no longer appropriate
• Real and nominal variables are highly intertwined
• This means changes in the money supply can temporarily push real GDP away from its long run trend

Question 16

AD curve

Answer 16

shows the quantity of goods/services that economic agents including customer abroad want to buy at each price level

Question 17

AS curve

Answer 17

shows the quantity of goods/services that firms choose to produce and sell at each price level

Question 18

What are the three effects which contribute to the AD curve slops downwards?

Answer 18

• Wealth effect (C) – the idea that an increase in an individual’s wealth will lead to an increase in their consumption (spending)
   Decreases in the price level increases the real value of money, therefore consumers feel wealthier and increase their spending so AD increases

Interest rate effect (I)
* Decreases in the price level decreases the interest rate, as households need to hold less money at lower prices, therefore they reduce their money demand. This stimulates spending on investment goods and an increase in quantity demanded of goods/services

Exchange rate effect (NX)
 A decrease in the UK price level causes a decrease in the interest rate. This means the UK pound depreciates net capital outflow increases and the supply of the pound of forex markets increases. This increases the UK’s net exports and leads to an increase in the quantity demanded of goods/services.

Question 19

Net capital outflow (NCO)

Answer 19

the net flow of funds being invested abroad by a country during a certain period (usually a year)

Question 20

What causes a shift in the AD curve?

Answer 20

Changes in consumption, C
 Changes in taxes, wealth, money supply (which affects interest rates) or anything else that change how much people what to consume at a given price level

Changes in investment, I
 Better technology, changes in taxes or money supply (which affects interest rates) or anything else that changes how much firms want to invest at a given price level

Changes in government spending, G
 Policy makers change government spending at a given price level e.g., building new roads, hospitals etc

Changes in net exports, NX
 Recessions in Europe, international speculators changing the exchange rate, changes in the money supply (which changes interest rate) or anything else that changes net exports for a given price level

Question 21

LRAS curve

Answer 21

a curve that shows the relationship between price level and real GDP that would be supplied if all prices, including nominal wages, were fully flexible

Question 22

What causes a shift in the LRAS curve

Answer 22

Changes in labour
 Immigration, births, change sin frictional and structural unemployment due to government policy (minimum wage, etc)

Changes in capital

Changes in natural resources

Changes in technological knowledge

Question 23

What do we get when we bring together the AD curve and the LRAS curve?

Answer 23

the long run behaviour of the macroeconomy

Question 24

What do continual rightward shifts in the LRAS curve mean?

Answer 24

technological progress

Question 25

When does the LRAS curve experience a rightward shift?

Answer 25

as the economy becomes better able to produce goods/services over time, due to technological progress

Question 26

What causes a rightward shift in the AD curve?

Answer 26

monetary policy (the Bank of England increasing money supply over time)

Question 27

What are three reasons why the SRAS curve is upward sloping?

Answer 27

Sticky-wage theory
 Nominal wages are slow to adjust to changing economic conditions due primarily to the fact that labour contracts are fixed in the medium term and workers will fight against a reduction in pay, and so a firm will seek to reduce costs elsewhere, including via layoffs, if profitability falls.
 This explains the upward sloping SRAS curve as if the price level is less than the level expected then firms have less incentive to produce, therefore output decreases.

Sticky-price theory
 Prices of some goods/services are slow to adjust to changing economic conditions and come firms face menu costs when trying to adjust their prices
 This explains the upward sloping curve because if prices are lower than expected then some firms have higher prices than consumers desire, which means their sales will decrease and so will the firms’ output

Misperceptions theory
 Changes in the overall price level can temporarily mislead suppliers about changes in individual markets (if they infer changes in absolute prices as change in relative prices). Suppliers respond to changes in the level of prices
 This explain the upward sloping curve as if prices are lower than expected then some suppliers think this is a fall in relative demand for their product so they respond by producing less

Question 28

What causes shifts in the SRAS curve

Answer 28

• Changes in labour, capital, natural resources, or technological knowledge (all the factors that shift the LRAS curve)
• Expected price increases (cause a leftward shift (up) in the supply curve)