Wk 7 - The IS-LM/AD-AS Model: A General Framework for Macroeconomic Analysis

Question 1

What causes a right shift in the FE line?

Answer 1

• Beneficial supply shocks
• Increase in labour supply
• Increase in the capital stock

Question 2

What causes a left shift in the FE line?

Answer 2

• Unbeneficial supply shocks
• Decrease in labour supply
• Decrease in the capital stock

Question 3

Effect of beneficial supply shock (productivity shock) on the FE line

Answer 3

• Production of output increases for the same amount of capital and labour.
• Increase in MPN leads to a rise in labour demand and employment.

Question 4

Effect of an increase in labour supply on the FE line

Answer 4

Equilibrium employment increases, rising full-employment output.

Question 5

Effect of an increase in the capital stock on the FE line

Answer 5

More output can be produced with the same amount of labour. In addition, increased capital may increase the MPN, which increases labour demand and equilibrium employment.

Question 6

What does the IS curve show?

Answer 6

For any level of output Y, it shows the real interest rate r for which the goods market is in equilibrium.
It reveals the relationships between the real interest rate and output for which investment equals saving.

Question 7

What happens to the IS curve when any change causes a reduction in desired national saving relative to desired investment?

Answer 7

• Shifts IS curve up and to the right.
• In the case of constant output, decreased saving means more investment relative to saving; interest rate must rise to reduce investment and increase saving.

Question 8

What happens to the IS curve when any change causes an increase in desired national saving relative to desired investment?

Answer 8

Shifts IS curve down and to the left.
- Interest rate must

Question 9

What cases cause the IS curve to shift up and to the right?

Answer 9

• Increase in expected future output
• Increase in wealth
• Temporary increase in govt. purchases
• Decline in taxes (If Ricardian equivalence doesn’t hold)
• Increase in the expected future marginal product of capital
• Decrease in the effective tax rate on capital

(Opposite will happen to the six factors above if IS curve shifts down and to the left.)

Question 10

What is the relationship between price of a nonmonetary asset and interest rate?

Answer 10

It is inversely related. As price decreases, the interest rate increase (when you are still receiving the same amount in the future).

Question 11

How is the LM curve derived?

Answer 11

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

Question 12

What does the LM curve show?

Answer 12

• Reveals the combinations of the real interest rate and output that clear the asset market.
• Basically, it reveals the real interest rate required to equate real money demand and supply.
• Hence, LM curve slopes upward from left to right.

Question 13

What causes the LM curve to shift upwards?

Answer 13

• Any change that reduces real money supply relative to real money demand
• Decrease in real money supply relative to real money demand causes equilibrium real interest rate to rise.

Question 14

What causes the LM curve to shift downwards and to the right?

Answer 14

• Increase in the nominal money supply
• Decrease in price level
• increase in expected inflation
• decrease in the nominal interest rate on money
• decrease in wealth
• decrease in the risk of alternative assets relative to the risk of holding money
• increase in the liquidity of alternative assets
• increase in the efficiency of payment technologies

LM curve shifts up and to the left when the opposite happens to the eight factors listed above.

Question 15

When does a general equilibrium occur?

Answer 15

Where all markets are simultaneously in equilibrium. Occurs where the FE, IS, and LM curves intersect.

Question 16

Classical version of the IS-LM model

Answer 16

Keep in mind: economy is brought into general equilibrium by adjustment of the price level.
Classical economists see rapid adjustment of price level
- Adjustment is almost immediate if firms were to change prices instead of output in response to a change in demand.

Question 17

Keynesian version of the IS-LM model

Answer 17

• Slow adjustment of price level
• May take several years before prices and wages adjust fully.
• When not in general equilibrium, output is determined by aggregate demand at the intersection of the IS and LM curves, and the labour market is not in equilibrium.