Week 9 ISLM

Question 1

Future GDP increase: IS curve shift? Clearing R?

Answer 1

IS shifts out and right Saving decreases (consumption increases) because you know income is increasing in the future but you don’t have it yet. Savings curve shifts in, clearing interest rate increases.

Question 2

G increase: IS curve shift? Clearing R?

Answer 2

IS shifts out and right Saving decreases since S= Y - C - G so saving curve shifts in, clearing interest rate increases.

Question 3

Future MPK increase: IS curve shift? Clearing R?

Answer 3

IS curve shifts out and right Higher MPK f increases investment so shifts investment curve out to the right ( more I at same r) so clearing interest rate increases.

Question 4

What happens to IS curve if there is a permanent increase in GDP?

Answer 4

Up and out You consume more so saving falls. Curve shifts in and R increases to clear goods mkt

Question 5

Tax increase: IS curve shift? Clearing R?

Answer 5

If we assume Ricardian Equivalence, IS does not move If we assume no RE, people think it’s a permanent tax increase so they consume less and save more. IS shifts in and down because consumption decreases, clearing interest rate decreases

Question 6

What happens to IS curve if effective tax rate on capital increases?

Answer 6

IS shifts in and left Investment decreases so shifts left and in ; r decreases

Question 7

Whats shifts Full Employment line in the Y vs. R graph to the right?

Answer 7

1) beneficial supply shock (lower oil prices, higher tfp (more output for same labor) 2) MPN increase actually increases labor demand and employment ruses, so FE line shifts out 3) increase in labor supply 4) increase in capital stock (MPN increases so labor demand increases)

Question 8

Tax increase: IS curve shift? Clearing R?

Answer 8

If we assume Ricardian Equivalence, IS does not move If we assume no RE, IS shifts in and down because consumption decreases, clearing interest rate decreases

Question 9

Savings increase and curve shifts out and right. IS curve?

Answer 9

Out and right.

Question 10

Savings decrease or investment increase. IS curve?

Answer 10

IS shifts in. R increases.

Question 11

Which way does the IS curve slope, and what are the axes?

Answer 11

Downward sloping curve. Axes are Y on x axis and R on y axis.

Question 12

Which way does the LM curve slope, and what are the axes?

Answer 12

Upward sloping curve. Axes are Y on x axis and R on y axis.

Question 13

Price level P, increases: LM shift? Clearing R?

Answer 13

LM shifts up and left Real money supply decreases, clearing R increases

Question 14

Nominal interest rate increases: LM shift? Clearing R?

Answer 14

LM shifts up and left Demand for money increases, clearing R increases

Question 15

Permanent wealth increase: IS curve shift? Clearing R?

Answer 15

IS shifts out and right Saving decreases (consumption increases) and shifts in, clearing interest rate increases.

Question 16

Price level P, increases: LM shift? Clearing R?

Answer 16

LM shifts up and left Money supply decreases, clearing R increases

Question 17

Expected inflation increases: LM shift? Clearing R?

Answer 17

LM shifts out and right Money demand shifts down, clearing interest rate goes down.

Question 18

Increase in real money demand: LM shift? Clearing R?

Answer 18

LM shifts up and left Money demand curve shifts up, clearing R increases

Question 19

Increase in nominal money supply M: LM shift? Clearing R?

Answer 19

LM shifts out and right Money supply moves out, clearing interest rate goes down

Question 20

Expected inflation increases: LM shift? Clearing R?

Answer 20

LM shifts out and right Money demand shifts down, clearing interest rate goes down (??)

Question 21

Decrease in real money demand (decrease in Y): LM shift? Clearing R?

Answer 21

LM shifts out and right Clearing interest rate goes down.

Question 22

Savings increase. What happens to goods market equilibrium?

Answer 22

Savings slopes upwards on the S,I and R graph. So if savings increase, the curve shifts out/right and the clearing interest rate decreases.

Question 23

Savings decrease. What happens to goods market equilibrium?

Answer 23

Savings slopes upward on the S,I and R graph. So if savings decrease, the curve shifts in/left and the clearing interest rate increases.

Question 24

How do you derive the IS curve?

Answer 24

Hold investment curve constant and vary GDP to shift savings curve up and in– you get a downward sloping curve on Y versus R as a result. (As Y increases, clearing R decreases for the IS curve)

Question 25

Investment decreases. What happens to goods market equilibrium?

Answer 25

Investment slopes downward on the S,I and R graph, so if investment decreases, the clearing interest rate shifts down and left and decreases.

Question 26

When the ISLMFE curves are out of equilibrium due to a shock, which market is quickest to adjust?

Answer 26

LM curve, because the economy is brought into equilibrium through adjustment of the price level.

Question 27

How do you derive the IS curve?

Answer 27

Hold investment curve constant and vary GDP to shift savings curve up and in– you get a downward sloping curve on Y versus R as a result. (As Y increases, clearing R decreases for the IS cruve)

Question 28

How do you derive the LM curve?

Answer 28

Hold money supply constant and vary money demand with different levels of GDP to shift it up and down– you get an upward sloping curve of Y versus R as a result. (As Y increases, clearing R increases for LM curve)

Question 29

When the ISLMFE curves are out of equilibrium due to a shock, which market is quickest to adjust? Why?

Answer 29

LM curve, because so long as aggregate demand is bigger than supply prices will adjust to catch up.

Question 30

What does monetary neutrality mean?

Answer 30

Change in monetary supply changes price levels proportionately but has no effect on real variables.

Question 31

How do you derive the aggregate demand (AD) curve?

Answer 31

By holding IS constant and shifting LM by changing the price level. The higher the price level, the higher the interest rate so the AD curve slopes downward on a graph of Y (AD) versus P

Question 32

What happens to the AD curve if government spending increases?

Answer 32

AD shifts out and up. Government spending decreases savings, which shifts IS out. That increases equilibrium R with LM, ultimately increasing the P at which that same R exists.

Question 33

Generally speaking, what shifts the AD curve out?

Answer 33

Anything that moves the equilibrium between IS and LM up to a higher R (to the right).

Question 34

Generally speaking, what shifts the AD curve in?

Answer 34

Anything that moves the equilibrium between IS and LM in and down to a lower R (to the left).

Question 35

Summarize everything that can move the IS-LM equilibrium up and to the right.

Answer 35

1) increase in expected future output 2) more wealth 3) more government spending 4) lower taxes and no RE (more spending) 5) higher future MPK 6) lower effective tax rate on capital

Question 36

Summarize everything that can move the IS-LM equilibrium down and to the left.

Answer 36

1) increase in nominal money supply 2) rise in expected inflation 3) decrease in nominal interest rate on money 4) any other changes that reduces money demand

Question 37

Why is the short run aggregate supply curve horizontal?

Answer 37

Because in the short run, prices remain fixed and firms can’t vary or change prices, so firms supply whatever output is demanded

Question 38

What shifts short run aggregate supply curve?

Answer 38

Firms changing their prices in the short run Due to increases in prices such as cost of labor or inputs (shift SRAS up) Due to lower prices (shift SRAS down)

Question 39

What shifts long run aggregate supply curve?

Answer 39

Anything that increases full employment output. Anything that decrease full employment output shifts LRAS left ex. change in labor force or productivity changes that affect labor demand

Question 40

What are the axes on the AD and LRAS, SRAS graphs?

Answer 40

GDP and P

Question 41

What happens to AD curve when P increases or decreases?

Answer 41

Move along the curve

Question 42

What happens to AD curve when expected inflation increases or decreases?

Answer 42

Shifts curve in or out. Money demand is decreasing in Pe, so an increase in expected inflation reduces money demand, lowering clearing interest rate– LM shifts out – AD shifts in/left. Decreasing expected inflation increase money demand, increasing clearing interest rate – LM shfits up and in – AD shifts out/right.

Question 43

What happens to the IS curve when there is a one-time increase in current GDP or wealth?

Answer 43

You save the extra wealth since it’s temporary. Savings increase, curve shifts out so clearing R goes down. IS curve shifts in and left.

Question 44

Investment decreases due to lower MPK or higher effective tax rate. What happens to the clearing R and IS?

Answer 44

Investment curve shifts in and down, decreasing the clearing R. IS curve shifts down and left.

Question 45

Express the labor supply curve in its analytical form.

Answer 45

N^s= n₀ +n_w(1-t)w

n₀ captures factors such as wealth and the size of the working age popultion

Question 46

What is the analytical form for consumption in the goods market?

Answer 46

C = c₀ + c_y(Y-T) - c_rr

Y-T is disposable income

c_y is the marginal propensity to consume: C is increasing in this, though it’s safe to assume it’s less than 1 cuz you don’t consume everything you get

c₀ is factors that affect desired consumption such as wealth or expected future income

c_r shows that consumption is decreasing in the interest rate, since it’s a negative coefficient

Question 47

What is the analytical functional form for investment?

Answer 47

Id = i₀ -i_rr

where i₀ captures things that affect desired investment level such as MPK.

This function is decreasing in r, as shown by the sign of i_r

Question 48

What is the analytical form of the asset market curve?

Answer 48

M^d/P = l_{<span>0</span>}+ l_y*Y - l_r (r+π^e)

Where l₀is factors that increase money demand such as liquidity or riskiness of other assets, payment technologies

It makes sense that the function is increasing in l_y because you want more money to do more transactions as GDP increases, and it makes sense that it is a decreasing function of the interest rate and expected inflation so l_r is negative.

Question 49

Why does the fiscal multiplier matter? How is it defined?

Answer 49

Fiscal multiplier is ΔY/ΔG. It is bigger if LM is flat, and smaller if LM is steep.

Question 50

What is β_LM?

Answer 50

β_LM is l_y/l_r

it is the ratio of the sensitivity of money demand to increases in income/GDP to the sensitivity of money demand to the interest rate. β_LM is higher when sensitivity to output is high and low sensitivity to R. Makes intuitive sense if you consider the axes of LM curve (Y, R).