EC 202 Midterm #2

Keynesian vs Classical Theory

1. Aggregate Demand Classical: downward sloping based on Quantity Theory of Money Keynesian: downward sloping based on IS-LM in real terms (real money balance effect) 2. Aggregate Supply Classical: perfectly flexible wages and prices (vertical AS) Keynesian: wage stickiness, gradual adjustments of wage rate (upward sloping AS) 3. Effect of AD Policies Classical: MS increases, price increases w/o change in level of output. G increases, no change in AD because of full crowding out (no effect on P or y) Keynesian: AD policies are effective. AD is an important factor to determine the level of output 4. Policy prescription classical: non-interventionist Keynesian: the instability of AD is the major cause of the instability of the economy. AD policies are useful tools for stabilizing the economy

how do changes in autonomous expenditures like investment affect equilibrium in IS-LM.

A decline in investment spending shifts the investment schedule left by the change in I, causing investment to decrease at each interest rate. the result is a shift of the IS curve left. Income falls from Y0 --> Y1 because investment at the initial interest rate has fallen. As income falls, income-induced consumption also declines. The interest falls from r0 --> r1 as a result of income reduction (Md decreases and Bd rises). The decrease in interest rates causes investment to rise again, making up for some of the decrease in income and consumption.The effects are a decrease in income and interest rates. (Partial crowding out). The difference between IS curves is [1/MPC].

what is a liquidity trap?

A liquidity trap occurs when the interest elasticity of Md becomes extremely large, approaching infinity. When the interest rate becomes very low, a consensus forms thinking the interest rate will increase in the future. Thus, people are more inclined to hold their money. In the liquidity trap case, the Md curve is no longer linear. The curve starts steep and flattens as the interest rate lowers. At low levels of income the equilibrium interest rate is very low, so the equilibrium point hits the flat part of the Md curve. Here, increasing income from Y0 to Y1 requires a small increase in interest rate. however, as income increases, the increase in interest rate necessary becomes much larger.

What variables will shift the position of the IS schedule? Explain how a change in each variable will shift the schedule (left or right)

An increase (decrease) in the level of government spending will shift the IS schedule to the right (left). An increase (decrease) in taxes will shift the IS schedule to the left (right). An autonomous increase (decrease) in investment or consumption demand will shift the IS schedule to the right (left).

What variables will shift the position of LM schedule? Explain how a change in each variable will shift the schedule (left or right)

An increase (decrease) in the money supply will shift the LM schedule to the right (left). A shift in the money demand function, in the sense of an increase (decrease) in the amount of money demanded for given levels of income and the interest rate, will shift the LM schedule to the left (right).

what is the effectiveness of fiscal policy on IS Schedule

An increase in G causes IS curve to shift to the right. Fiscal Policy is much more effective where investment is less sensitive to the interest rate. This is because, as income increases, the interest rate must rise to keep the money market in equilibrium. This causes investment to decline, partially offsetting the expansionary effect of the government spending increase. Such interest rate induced decline in investment causes the income response in IS-LM to fall short of the horizontal shift in the IS schedule. a larger interest elasticity of investment will mean that more of the expansionary effect of an increase in government spending will be offset by an interest rate induced decline in investment, and thus the greater will be the crowding-out effect. When IS is steep, investment is relatively interest inelastic. This means investment is not that sensitive to changes in interest rate, and will only drop by a small amount when r increases. The income will rise by almost the full amount of the horizontal shift in the IS schedule. When IS is flat, investment is relatively interest elastic, and investment is very sensitive to changes in interest rate. When interest increases, there is a large decrease in investment, and the increase in income will be reduced substantially relative to simple Keynesian model predictions. When IS is vertical, investment is completely inelastic, and the increase in interest rate has no effect on investment, and income increases by the full amount of the horizontal difference. there is no crowding out of investment.

How do changes in autonomous spending or taxes shift the IS curve?

An increase in G will result in the I(r)+G curve shifting right at a given interest rate. In order for I+G =S+T to remain, the value of S must increase. Thus, I(r) +G1 = S1+T with the increase in G. The increase in S increases income from Y0--> Y1. on an IS curve, the interest remains constant, but the income increases. this can be shown by a shift right, where at r0, the income increases from Y0-->Y1. The horizontal difference in IS curves is the government expenditure multiplier (1/1-b). An increase in Taxes has zero effect on the I+G curve (and thus no effect on interest rate). However, The increase in taxes results in a leftward shift of the S+T curve. At the fixed I+G point on this graph, income decreases from Y0 --> Y1. Thus, on an IS curve, at a fixed interest rate, the curve shifts left and the income equilibrium value decreases. The horizontal difference is the tax multiplier [-b/1-b] An increase in investment demand shifts I(r) + G to the right, yielding the same result as an increase in G.

how do changes in money demand shift the LM curve?

An increase in Md for a given level of income and interest rate would result in a shift of Md curve right. seeing as Ms is a fixed vertical curve, this results in an increase in interest rates in the money market. As income remains fixed, the increase in just interest rate forces the LM curve to shift upward and left

Effects of a Change in MS

An increase in Money supply shifts the Ms curve right. At r0 now there is excess supply of money. Here people are not content with holding all this new money, so people start to buy bonds. The increase in demand for bonds results in a decrease in interest rates. when the interest rates fall, speculative demand causes consumers to assume interest rates will rise in the future, so they begin to hold their money and wait to buy bonds when they become cheaper. This increases the Md until it reaches a new equilibrium point with Ms1. The net result is a decrease in interest rate.

What is the effectiveness of Monetary Policy on IS Schedule

An increase in Ms causes the LM curve to shift right. Monetary policy influences income by lowering interest rate and stimulating investment. When the IS curve is steep, there is low interest elasticity of investment (Eir). This means income increases by only a small amount. So the expansionary monetary policy is relatively ineffective. When the IS curve is flatter, there is a high interest elasticity of investment. This means income increases by a large amount, and expansionary monetary policy is relatively effective. When the IS curve is vertical there is no change in income and therefore expansionary monetary policy has no effect

Effectiveness of AD policies with upward-sloping AS curve

An increase in Ms results in lm shifting out at a given price. The shift results in r decreasing in the money market. Investment then increases, causing AD to increase. The shift out of AD at P0 makes AD>AS. thus price rises. As price rises the real money stock decreases and lm shifts back. the new equilibrium is (y2,P1). The net effect is an increase in y when Ms increases. (the effect is smaller with flexible P than fixed P). When G increases, is shifts out for a given P0. This causes the AD to shift out and AD>AS. Price will rise and real money stock will decrease. thus, lm will shift backwards. The net effect is an increase in y, but the effect is smaller with a flexible P. the more flexible P and W, the less effective Fiscal policy

How would the level of aggregate demand be affected by a rise in the interest rate in the Keynesian theory? Which components would be affected most strongly?

An increase in the interest rate would cause aggregate demand to fall in the Keynesian theory. Construction investment and fixed business investment would be the components of aggregate demand that would be most strongly affected. Consumer durable goods purchases would also decline.

How does equilibrium income and interest rate change with changes in money

Changes in Ms and Md will only affect the LM curve. In the money market, an increase in Ms shifts the Ms curve to the right, creating excess Ms at a given interest rate. People begin to buy more bonds, which causes the interest rate to decrease. the decrease in interest rate shifts Md up to a new equilibrium point in the money market. The result is a shift of LM curve to the right (r decreases). As r decreases, investment spending increases. The increase in investment spending causes an increase in income, with a further, income-induced increase in consumption. A new equilibrium point is achieved when the combined fall in r and increase in Y increases Md curve to equal the new Ms. The Net effect is a decrease in r and increase in Y. (the inverse occurs when Ms falls). An increase in Md (shift in liquidity preference) shifts the LM curve left. As people get rid of Bonds and acquire money, the interest rate will rise. The higher interest rate will cause investment spending to decrease, and therefore income will decrease. In the IS-LM model, the shift of LM causes a new equilibrium point to be made where r is higher and Y is lower. (same effect as fall in Ms). (inverse occurs when Md falls).

How do changes in money shift the LM curve?

Changes in Ms will shift the LM curve. If Ms increases, the curve will shift right. People will begin buying more bonds, so Bd will increase. This will cause the interest rate to drop. however, because income is fixed (no movement of Md), on an LM curve, only the r decreases for a given equilibrium point. The net effect of this on the LM curve is: shift down and to the right. (the inverse occurs when there is a decrease in Ms)

what is the Keynesian AD with Classical AS? Assumptions?

Classical Assumptions: wage is fully adjusted to the changes in P (Vertical AS). An increase in government spending shifts the AD schedule to the right from Yd0 --> Yd1. At the current price level, AD>AS. Price will rise to re-equilibrate the market. As price rises, real money stock will start to decrease (lm curve shifts to the left). As lm shifts left, interest rates begin to rise, causing I to fall. The effect is full crowding out as y returns to Y0. (AD has no role in affecting the level of output) An increase in money supply causes the lm curve to shift to the right. This shift causes interest rate to increase, ultimately causing I to fall. Thus, full crowding out occurs and y returns to y0. (M has no role in affecting the level of output)

How do changes in G or T change the equilibrium income and interest rate

Fiscal Policy variables affect IS curve. Increase in G causes I(r)+G curve to shift right, and further causes S+T to increase as well. The result in product market is an increase in income from Y0-->Y1 at a given interest rate. In the IS-LM model, the IS curve will shift right. At a fixed interest rate, the income increases from Y0--> Y'1. This creates a horizontal difference of [1/MPC]. The increase in Y causes an increase in transaction Md, which means Bd falls and people want money (r increases). the increase in r causes speculative Md to decrease, and people being to hold money. interest will increase and Y decreases until a new equilibrium point is reached. Net effect, increase in r and y. (partial crowding out). Increase in Taxes will cause the amount of disposable income (y-T) to decrease. this will result in a decrease in y, and a decrease in consumption in the product market. This results in IS shift left at a given interest rate. the horizontal difference is [-b/MPC]. Here, the decrease in income causes a decrease in Md, as people want to buy more bonds. the Decrease in Md causes interest rate to decrease. The decrease in interest rate causes Investment spending to increase. the increase in I partially offsets the decrease in consumption from the Tax increase. Eventually interest falls until a new equilibrium is reached. Net effect: decrease in r and y.

IS-LM equilibrium in respects to Y and r

IS-LM equilibrium point is the combination of r and y that produces equilibrium in both the money and product market

What is the Role of Money in Keynesian Theory

In the Keynesian Theory, price and wages are assumed fixed. In these cases, an increase in money supply will decrease the interest rate, which in turn, increases Investment spending. This increases Aggregate Demand and income. all financial assets are divided into money and bonds. Equilibrium is where the supply of money = demand for money OR where the supply of bonds = demand of bonds.

Explain the Keynesian theory of interest-rate determination. What differences do you see between this theory and the classical theory of the interest rate?

In the Keynesian theory, the equilibrium interest rate is the rate, which equates money demand with the fixed money stock, where money demand is a function of income and the interest rate. In the classical system, the equilibrium interest rate is the rate that equates the supply and demand for loanable funds. Keynes' theory focuses on money and the equilibrium between the stock of money and the demand for that stock. The classical theory focuses on flows in the credit market. Consequently, in the equilibrium classical system, the level of the money stock does not affect the level of the interest rate. In the Keynesian system flow supplies of demands for credit, such as the government's supply of bonds to finance a deficit, do not directly affect the interest rate.

Explain why at a point such as B in figure 6-17, there is a downward pressure on both the level of output and the interest rate.

Interest rate- all points above the LM schedule will have an excess Ms. Further, at the given level of income for B, the corresponding r is too high for the money market equilibrium, so there is downward pressure on r. Output- Point B is above the IS curve, which means Y is greater than the equilibrium level. The aggregate demand is too low to support this level of output at the given r, so there is a tendency for output to fall.

What does Ms, Md curve look like

Money supply curve is vertical (perfectly inelastic) because it is assumed fixed. the Md curve is downward sloping. where they intersect is at the equilibrium interest rate

Examples of negative and positive supply shocks

Negative Supply Shock An increase in oil price causes the cost of production to increase. this means firms will produce less for a given P, or raise P to produce the same amount of output. This causes AS to shift left, resulting in higher P and lower Y (stagflation) Positive Supply Stock increases in productivity advances in technology

why is the government multiplier effect smaller in the IS-LM than in the Simple Keynesian Model?

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Effects of AD-policies under a negative supply shock

Policy Dilemma in Negative Supply Shock Expansionary AD policies will increase y, but P will also increase further Contractionary AD policies will decrease P, but y will decrease further. AD policies cannot prevent both increasing price level and decreasing output

What is the product market equilibrium? What does IS curve show?

Product market equilibrium are values of interest rate and income where savings = investment. The IS curve shows the various equilibrium points as a function of interest rate and income.

why does Md = L(y,r)

Speculative Demand: consumers will demand more money when interest rates in the present falls. Transaction + Precautionary Demand: more money is demanded when income increases but less is demanded when interest increases When you combine these two you get the Total Demand of Money. Md is positively related to income and negatively related to interest rates

Why is Keynesian AD curve downward sloping?

The AD curve is downward sloping because of the Real Money Balance Effect. An increase in price will result in a decrease in the real money stock (m = M/P) (this is shown with LM curve shifting left). This creates an excess demand for money, which in turn means interest rates must rise to achieve equilibrium. As interest rates rise, I falls and output demanded falls. the net effect is a decrease in output (real income).

Why is the LM curve upward sloping?

The LM curve is upward sloping because as income levels get higher, equilibrium points on the LM curve require higher interest rates. because income affects Md curve, an increase in Y at a given r causes the curve to shift right due to the transaction demand. This shift right will then cause interest rates to rise, as Ms is vertical curve.

What is the money market equilibrium? What does the LM curve show?

The money market equilibrium is at points where Ms curves intersect Md curves. The LM curve shows the various equilibrium points in the money market as functions of interest rate and income.

what is the effectiveness of fiscal policy on LM schedule

The slope of LM os heavily dependent on the interest elasticity of money demand. At progressively lower values of interest elasticity of money demand, the LM schedule becomes steeper. When the LM curve is flat, Expansionary fiscal policy is most effective. The increase in G causes income to increase. as income rises, demand for transactions balances increases. to re-equilibrate the money market requires an increase in interest rate. The rise in interest rate lowers speculative demand for money and causes consumers and firms to decrease their demand for money. When the curve is flat, only a small rise in interest rate is necessary to restore equilibrium to the money market. Thus, the decline in investment is also small. with minimal crowding out by investment, income rises by nearly the full amount the horizontal shift in IS schedule. When LM is steep, expansionary fiscal policy is less effective, and money demand is interest inelastic. A greater interest rate increase is required to re-equilibrate the money market. The larger increase in interest rate means a larger decline in investment spending, offsetting more of the expansionary effect of the increase in government spending. Thus, increase in income is smaller.

What are the three motives for holding money according to Keynes's theory of money demand? Explain each motive.

Transaction Demand- the amount of money held for transactions vary positively with the volume of transactions engaged in (i.e. pos with income). Demand for money is negatively related to the interest rate as the incentive to make expenditures required for cash management depends on the interest rate. Precautionary Demand- additional money is held in the case of unexpected expenditures. Depends positively on income. Motives are similar to transaction demand Speculative Demand- Individual demand for money depends on one's interpretations about future interest rates. Individuals have a relatively fixed conception of the normal interest rates. If the rate deviates from this, they will expect it to return to that normal level and act according. A decline in interest rate results in capital gain on previously existing bonds, and visa versa. Thus, if an investor expects rates to fall, they expect a capital gain in bonds. therefore bonds are the preferred asset so demand for money decreases.

How does income adjust if Aggregate supply doesn't equal aggregate demand?

When AS >AD, the point is right of the IS curve. This also means S+T > I+G. At a given interest rate, the value where S+T = I+G is below the actual output level. Thus, there is a surplus of output. To get rid of this ESo, we must decrease the level out output (downward pressure). When AD>AS, the point is left of the IS curve. Here, S+T < I+G. At the given interest rate, the value where S+T = I+G is above the actual output level. Thus, there is a a surplus of demand for output. To get rid of this EDo, we must increase the level of output (upward pressure).

How does interest rate adjust if Money supplied doesn't equal Money demanded

When Ms >Md, the point is above the LM curve. Here, we see an interest rate that is too high for money market equilibrium (higher interest rate means less Md) and there is an Excess Ms. The only way to get rid of this ES is to decrease the interest rate (downward pressure). When Md>Ms, the point is below the LM curve. Here, we see an interest rate that is too low for money market equilibrium. There is Excess Md. To get rid of this ED we must increase interest rate (upward pressure).

Why is the Keynesian AS-curve upward sloping under rigid wages or sluggish adjustment of W to the actual price changes

With sluggish adjustment of W or rigid W, an increase in P would decrease the real wage rate (W/P). This would increase real profits to producers and cause an expansion of production with the price level. Thus, the AS curve is upward sloping.

Suppose: C = 60 + 0.8Yd I = 150 - 10r G = 250 T = 200 M^s = 100 M^d = 40+0.1Y - 10r a) write the equation for the IS and LM schedules b) Find the equilibrium values for income (Y0) and the interest rate (r0)

a) IS: Y = C + I + G --> 0.8Y = 10r - 300 => [Y = 1500 - 50r] LM: Ms = Md --> 100 = 40+ 0.1Y - 10r => [Y = 600 + 100r] b) r(0) = 6 and Y(0) = 1200

What is the effectiveness of Monetary Policy on LM Schedule

an increase in money supply shifts the LM curve right. Monetary policy is least effective when LM schedule is relatively flat. When the LM curve is flat, the initial increase in money supply creates an excess of money supply, causing the interest rate to fall as Bd increases. This will stimulate investment and then income. the interest must decline to a point where the lower interest rate and higher income have gotten rid of the excess money supply. when money demand is sensitive, it takes a relatively small decrease in interest. When LM curve is steep, it requires a much larger decrease in r to re-equilibrate the money market. thus, investment and income increase by a greater amount.

Why is the IS curve downward sloping?

for higher interest rates the equilibrium income is lower

what is the effectiveness of economic policies when an economy is in a liquidity trap?

monetary policy is ineffective in cases of liquidity traps. The LM curve is very flat, reflecting high interest elasticity of Md. this is because at such low levels of r, the speculative demand curve for money would become very flat: future r would increase. an increase in Ms would only be absorbed with a slight fall in interest rate and minimal investment stimulation. Fiscal policy should be the most effective in the case of a liquidity trap. The Flat LM curve means minimal crowding out.