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