IS-LM model

By considering only the goods market equilibrium equation in the IS-LM model, if the marginal propensity to consume is 0.6, and government expenditures and taxes are both increased by 10, equilibrium income will rise by:

100 (*government expenditures and taxes are both increased by 10)

A movement along an aggregate demand curve corresponds to a change in income in the IS-LM model_______, while a shift in an aggregate demand curve corresponds to a change in income in the IS-LM model________.

A movement along an aggregate demand curve corresponds to a change in income in the IS-LM model resulting from a change in the price level, while a shift in an aggregate demand curve corresponds to a change in income in the IS-LM model at a given price level.

The multiplier for tax indicates how much ___________ change(s) in response to a $1 changes in taxes.

Income

In the IS-LM model when M remains constant but P rises,

LM curve shifts to the left.

The LM curve can shift to the right if there is an increase in the supply of money or a fall in the price level. In which case is this movement along the aggregate demand curve, and in which case is this a shift of the aggregate demand curve? Explain.

The aggregate demand curve shows the relationship between quantity of output demand, Y, and the price level, P (holding other factors constant). An increase in money supply means one of the other factors held constant is now changed. Hence, we must have a new demand curve, i.e., it is a shift of the original demand curve. A change in the price is just a movement along the demand curve (see also the derivation of the aggregate demand curve from the IS-LM diagram in your class notes).

The interest rate determines____ in the goods market and money ____ in the money market.

The interest rate determines Investment spending in the goods market and money demand in the money market.

The interest rate determines ______in the goods market and money ______ in the money market.

The interest rate determines investment spending in the goods market and money demand in the money market.

Planned expenditure or total demand in the goods market is a function of

Y&I&G&T

The IS-LM model simultaneously determines equilibrium in two markets. a. Which two markets? b. What two variables adjust to bring equilibrium in the markets?

a. Goods and money markets. b. The interest rate, r, and real output, Y.

Along any given IS curve:

both government spending and taxes are fixed.

A decrease in equilibrium output would be a result of

increase in money demand.

The IS curve generally determines:

neither income nor the interest rate.

A increase in the price level

similar to a decrease in rel money supply.

Based on the goods market equilibrium equation of the IS-LM model, one reason to support government spending increases over tax cuts as measures to increase output is that:

the government-spending multiplier is larger than the tax multiplier.

An increase in investment demand for any given level of income and interest rates,

will shift the IS curve to the right

An increase in the demand of money,

will shift the LM curve to the left

If the LM curve is vertical and government spending rises by G, in the IS-LM analysis, then equilibrium rises by

zero

The IS and LM curves together generally determine:

both income and the interest rate

Suppose Congress wishes to reduce the budget deficit by reducing government spending. Use the IS-LM model to illustrate graphically the impact of the reduction in government spending on output and interest rates. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; and v. the terminal equilibrium values.

A one-time increase in oil prices would increase, P in our model. Now use argument in question 7 above (basically M/P falls which shifts the LM curve up/left) to deduce that in the new equilibrium, interest rate must rise and output falls.

Explain why an increase in the money supply, which is a change in the money market, will upset the equilibrium in the goods market.

An increase in money supply will decrease the equilibrium interest rate in the money market at any given level of income. A lower interest rate will increase investment in the goods market, which will increase the equilibrium level of income in the goods market. Graphically, this is represented by a shift in the LM curve to the right (or downward) and a movement along the IS curve (when interest rate changes) to the new intersection point of the IS-LM curves.

In the goods market equilibrium equation in the IS-LM model, assume hat consumption (function) is given by C=100+0.6(Y-T). If (planned) investment is 100 and T is 100, then the level of G needed to make equilibrium Y equal 1000 is:

260 ( 1/1-mpc=5/2; mpc/1-mpc=3/2; effects of I and T on Y are 250 and -100; Y=I+G+T; Y=1000, 900 of G is needed; G*5/2=360; 360-100=260)

A variable that links the market for goods and services and the market for real money balances in the IS-LM model is the:

Interest Rate

Equilibrium levels of income and interest rates are ____ related in the goods and services market, and equilibrium levels of income and interest rates are ________ related in the market for real money balances.

Equilibrium levels of income and interest rates are negatively related in the goods and services market, and equilibrium levels of income and interest rates are positively related in the market for real money balances.

In the IS-LM model, if congress cut taxes,

IS curves shifts to the right.

In the IS-LM model with fixed prices, tightening/lowering the (nominal) money supply will ______ nominal interest rates in the short run and according to Fisher effect in the classical model (with the quantity theory of money equation), tightening the money supply will ____ nominal interest rates in the long run.

In the IS-LM model with fixed prices, tightening/lowering the (nominal) money supply will increase nominal interest rates in the short run and according to Fisher effect in the classical model (with the quantity theory of money equation), tightening the money supply will decrease nominal interest rates in the long run.

In the IS-LM model, when the federal reserve decreases the money supply, the Fed _____ bonds, and the interest rate_____, leading to a(n) _______ in investment and income.

In the IS-LM model, when the federal reserve decreases the money supply, the Fed sells bonds, and the interest rate rises , leading to a(n) decrease in investment and income.

In the IS-LM model when M rises but P remains constant,

LM curve shifts to the right

In the IS-LM model when M/P rises,

LM curve shifts to the right

In the goods market equilibrium equation, if taxes, T, are reduced by 100, then planned expenditures or total demand___________for any given level of income.

MPC(Y-T) Which indicates that it increase less than 100.

Reducing the money supply_____ nominal interest rates in the short run, and______nominal interest rates in the long run.

Reducing the money supply raises nominal interest rates in the short run, and lowers nominal interest rates in the long run.

Suppose firms are less optimistic about the future and decide to cut back on investment expenditure (regardless of the level of interest rate). Explain why such an exogenous decrease (a decrease that is not due to changes in interest rate) in investment, which is a change in the goods market, will upset the (original) equilibrium in the money market.

Since 'I' and 'G' appear in the same way in the expression C + I + G, an 'exogenous' change/shock (autonomous change) in investment spending (not caused initially by changes in interest rate) is (mathematically) equivalent to a decrease in government spending. This will lead, because of the multiplier effect, to a reduction in Y according to the goods market equilibrium equation. A decrease in income/Y would decrease the demand for money (so supply is now higher than demand in the money market), to restore equilibrium in the money market (bring demand back up), it means a lower interest rate is required. Graphically, this is represented by a shift of the IS curve to the left and a lower interest rate at the new intersection/equilibrium point.

Compare the predicted impact of an increase in the money supply in the liquidity preference model versus the impact predicted by the quantity theory and the Fisher effect. Can you reconcile this difference?

The IS-LM model predicts that an increase in money supply will decrease interest rate (as seen in the IS -LM diagram). The quantity theory predicts that an increase in money supply will increase price level or inflation, which, via the Fisher effect, will increase the nominal interest rate. The IS-LM model emphasizes the short-run effect when prices are fixed and Y is variable, while the quantity theory and Fisher effect are long-run effects when prices are flexible and Y is fixed (at full employment level). The results are different because of the different underlying assumptions.

Suppose Congress wishes to reduce the budget deficit by increasing taxes while the Fed would like to keep output unchanged. Use the IS-LM model to illustrate graphically the impact of both the fiscal and monetary policy on output and interest rates. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; and v. the terminal equilibrium values.

We did the increase in G in class. Now reverse the argument there to conclude that the IS curve must shift to the left if G decreases. Hence in the new equilibrium, both output and interest rate are lower (from the diagram).

Two identical countries, Country A and Country B, can each be described by a Keynesian-cross model. The MPC is 0.9 in each country. Country A decides to increase spending by $2 billion, while Country B decides to cut taxes by $2 billion. Find the tax and government multiplier for both countries. In which country will the new equilibrium level of income be greater?

We use only the goods market equation to answer the question. Income in country A will increase more. The multiplier for G is 1/ ( 1 - MPC ) = 10. The multiplier for T is only MPC / ( 1 - MPC ) = 9. Hence A has an increase in Y of 2*10 = 20 while the increase in B is only 0.9*20 = 18.

a. Suppose Congress decides to reduce the budget deficit by cutting government spending. Use the Keynesian-cross model to illustrate graphically the impact of a reduction in government purchases on the equilibrium level of income. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curve shifts; and v. the terminal equilibrium values. b. Explain in words what happens to equilibrium income as a result of the cut in government spending and the time horizon appropriate for this analysis

a. Please draw the IS - LM diagram. A reduction in government expenditure will shifts the IS curve to the left. Comparing the new equilibrium to the original one, we see that, at the new equilibrium, the income, Y, is lower. b. The equilibrium level Y is lower because of the multiplier effect. But the interest rate will be lower and that stimulates investment and partially offset the multiplier effect. But the net change in Y is still negative as seen in the diagram in part a. This analysis is appropriate for the short run (and prices are fixed - so there is no change in real money balances (M/P) or further shift in the LM curve).

Consider (only) the goods market equilibrium equation in the IS-LM model. Consumption is given by the equation C=200+2/3 (Y-T). Planned investment is 300, as are government spending, G, and taxes, T. a. write down the goods market equilibrium equation in its original form. b. What is equilibrium Y? c. What are equilibrium consumption, private saving, public saving, and national saving? d. How much does equilibrium income decrease when G is reduced to 200? What is the multiplier for government spending?

a. Y = C + I + G = 200 + 2/3(Y - T) + I + G. b. Using the equation in part a, we have: Y = 200 + 2/3( Y - 300) + 300 + 300 = 800 + Y*2/3 - 200 = 600 + Y*2 / 3. Solving for Y, we have Y = 1800. c. Consumption = 200 + 2/3( 1800 - 300 ) = 1200. Private saving = Y - C - T = 1800 - 1200 - 300 = 300. Public saving = T - G = 0. National or total saving = 300. d. The multiplier is 1 / (1 - MPC) = 3. Hence if G is reduced to 200 from 300, it means G is decreased by 100. Hence the decrease in Y is 3*100 = 300. 62. C, as this choice represents the LM curve. Note that the LM curve only intersects the IS curve at one point. Hence, only one point on the IS curve is consistent with money market equilibrium.

In the goods market equilibrium equation, fiscal policy(changes in G or T) has a multiplied effect on income because fiscal policy:

changes income, which changes consumption, which further changes income.