CH 12 - Building the ISL-LM Model

What is the theory of liquidity preference?

the interest rate adjusts to balance the supply and demand for money

Why do the 2 differ?

Because of unplanned inventory investment when sales do not meet expectations. As inventrories are counted as inestment expenditures by firms.

In summary, what does the Keynesian Cross show?

How income Y is determined for given levels of C, I and G, T.

What does the IS-LM model show?

How interactions between the goods and money market determine the position and slope of the aggreggate demand curve, and therefore the national income in the short run.

How does aggregate demand influence national income?

In the long run, where prices are flexible, only AS determines national income. In the short run, with sticky prices, AD influences income.

How does the economy reach equilibrium according to the Keynesian Cross?

Inventories play a big role in this. Whenever the economy is not in equilibrium, firms experience unplanned changes in inventories, and this causes them to change their production levels. Changes in production influence total income and expenditure, moving th eeconomy towards equilibrium

What does the interest rate depend on, according to the theory of liquidity preference?

It depends on the supply and demand for real money balances. This means that i adjusts to equilibriate the money market.

Does the demand for real money balances depend on the interest rate?

It does! That is because i is the opportunity cost of remaining liquid.

According ton Keyne's "The General Theory" what determines income in the short run?

It is determined largerly by how much households, businesses and the government are planning to spend. The more they want to spend, the more firms can sell. The more the firms sell, the more output they will produce and the more workers they'll hire.

What does each point of the IS curve represent?

It represents equilibrium in the goods market.

What does every point in the LM curve show?

It represents equilibrium in the money market.

Was the classical economic theory able to explain the Great Depression?

It was not. This is why economists tried to build a new economic model.

Who presented an alternative to classical theory?

John Maynard Keynes, in 1936.

What does the LM stand for? What does its curve show us?

Liquidity and Money The curve shows us what is happening to the supply and demand for money.

Why does the LM curve slope upward?

Lm curve is curve showing money market as money supply is held constant there is positive relation between output and interest rates because as to maintain balance between money demand and money supply thus it slopes upwards.

How does the demand for real money balances relate to i, and how does it relate to Y?

Negatively related to i. Positively related to Y.

Does the supply of real money balances depend on the interest rate?

No, it does not. The supply of real money balances is fixed.

What did Keynes argue?

That the low income and high unemployment were due to insufficient aggregate demand, and criticized the classicals for beleiving that aggregate supply alone determined national income.

What is Actual Expenditures?

The amounts households, governments and businesses actually spend. It is equal to GDP

What is Planned Expenditures?

The amounts they would like to spend

What is the variable that links the two halves of the IS-LM model?

The interet rate, since it ifluences both investment and money demand.

What relationship between variables does the LM curve show us?

The relationship between i and Y, the market for money balances!

What does the IS curve represent?

The relationship between income (Y) and the interest rate (i) in the markets for goods & services.

What is the goal of the IS-LM model?

To show what determines national income for a given price level.

What does the IS curve show us?

What level of income brings the goods & services market into equilibrium for any given i.

When is the economy in equilibrium according to the Keynesian cross?

When actual expenditures equal planned expenditures. Y=PE

What are the two interprentations of the IS-LM model?

You can look at the IS-LM model as showing how national income can change in the short run, or we can view this model as showing what makes the AD curve shift. The two interprentations are equivalent.

Why does the IS curve slope downward?

as the interest rate falls, investment increases, thus increasing output.

What does IS stand for? What does its curve show us?

investment and savings The curve represents what's going on in the market for goods and services.