Chapter 5: Goods+Financial Markets; IS-LM Model
What combination of monetary and fiscal policies can be used to fight a recession?
Same direction, monetary and fiscal expansion. Expansionary fiscal policy can decrease taxes and cause the IS curve to shift to the right. Expansionary monetary policy can shift the LM curve down. Both policies leads to higher output. Higher income and lower taxes imply a higher consumption. Higher output and lower interest rate imply that investment is also higher
IS Relation
Y = C (Y-T) + I (Y, i) + G
Determining Output (expanded IS Relation)
Y = C(Y - T) + I(Y, i) + G
An increase in output leads to a _______ in investment
increase
An increase in output leads to a _______ in investment?
increase
An increase in output leads to a ________ for the demand for goods
increase
For a given money supply, an increase in income automatically leads to a _________ in the interest rate
increase
An increase in nominal income _______ the demand for money
increases
An increase in taxes shifts the IS curve to the ________ and a _________ in output
left, decrease
We assume that the response of demand to output is ________ than one to one and draw a ZZ ______ than the 45 degree line
less, flatter
Higher interest rate leads to _________ investment and _______ demand
lower, lower
Policy Mix
the combination of monetary and fiscal policies
Equilibrium Condition
the condition that real money supply, that is, the money stock in terms of goods, not dollars, be equal to the real money demand, which depends on real income (Y) and the interest rate (i)
Confidence Band
the two dashed lines and tinted space between the dashed lines, which is a band within which the true value of the effect lies with 60% probability
The relation between demand and output, for a given interest rate, is represented by
upward sloping curve ZZ curve
Monetary Expansion
when the central bank decrease the interest rate, which then increases money supply
Monetary Contraction
when the central bank increases the interest rate, which then decreases money supply
What factors causes the IS curve to shift to the left and decrease equilibrium output (or decrease demand for goods)?
an increase in taxes or decrease in government spending or decrease in consumer confidence
Fiscal Expansion
an increase in the budget deficit due to an increase in government spending and keeping taxes unchanged or decrease in taxes
How did Bill Clinton want to reduce the budget deficit?
by decreasing government spending and increasing taxes he used fiscal contraction and monetary expansion
An increase in the interest rate ________ the demand for money
decreases
IS Curve: An increase in the interest rate ________ the demand for goods at any level of output, leading to a ________ in the equilibrium level of output
decreases, decreases
Equilibrium requires that the demand for goods be _________ to output
equal
Financial Markets: Equilibrium requires that money supply be ________ to money demand
equal
Fiscal Contraction
government decides to reduce the budget deficit by increasing taxes and keeping government spending unchanged
LM Curve
horizontal line as the central bank chooses the interest rate and adjusts the money supply so as to achieve it
For a given value of the interest rate, demand is an increasing function of output for what 2 reasons?
1) an increase in output (Y) leads to an increase in income and thus to an increase in disposable income (YD), which leads to an increase in consumption (C) 2) an increase in output (Y) also leads to an increase in investment ( I )
What does a monetary expansion do to the LM Curve and output?
A monetary expansion shifts the LM curve down and leads to a higher output
What happens to both the IS and LM Curve when there is a increase in taxes?
At a given interest rate, the increase in taxes decreases output, which ultimately shifts the IS curve to the left. The LM curve remains unchanged and does not shift because the interest rate did not change, but the economy moves along the LM Curve in correlation to the decrease in output
Investment, Sales, and Interest Rate
Investment depends on the level of sales and the interest rate I = I ( Y , i ) where output is positive and interest rate is negative
In the short run, an increase in federal funds leads to what?
It leads to a decrease in output and an increase in unemployment, but has little affect on the price level
What does a monetary contraction do to the LM Curve and output?
It shifts the LM curve up and leads to a lower output
Why is it better to use both policies? (fiscal and monetary)
a decrease in taxes may fail to increase consumption. a decrease in the interest rate may fail to increase investment
What factors causes the IS curve to shift to the right and increase equilibrium output (or increase demand for goods)?
a decrease in taxes or increase in government spending or increase in consumer confidence
Under the assumption that the central bank chooses the interest rate, the LM Curve is
a horizontal line
An increase in the interest rate due to a monetary contraction leads to a steady ____________ in output, with the maximum effect taking place after about 8 quarters
decrease
An increase in the interest rate leads to a ______ in investment
decrease
An increase interest rate leads to a _______ in investment?
decrease
The increase in interest rate decreases investment. The decrease in investment leads to a _________ in output, which further ________ consumption and investment, through the ________.
decrease, decrease, multiplier effect
IS Curve: Equilibrium in the goods market implies that an increase in the interest rate leads to a ________ in output. This IS Curve is therefore _________ sloping.
decrease, downward