5. Goods and Financial Markets; The IS-LM Model

Question 1

The Goods market and the IS relation

Answer 1

•Interest rate ↑ => investment ↓ => output ↓ => consumption ↓
The IS curve - the relation between the interest rate and output, represented by a downward-sloping curve
• Taxes ↑=> shift of the IS curve to the left ⃪

Question 2

Financial markets and the LM relation

Answer 2

•M = $Y L(i) : nominal income ↑ => Money demand ↑
nominal interest rate i ↑ => money demand ↓
• M/P = Y L(i)
Real money supply should be equal to the real money demand (which depends on real income, Y, and the interest rate, i.

Question 3

Putting the IS and the LM relations together

Answer 3

IS relation: Y = C (Y - T) + I (Y, i) + G (Equilibrium in the goods market)
LM relation: i = i fixed by the Central Bank (Equilibrium in the financial market)

Question 4

Fiscal Policy

Answer 4

Fiscal contraction (consolidation) - reducing the budget deficit by increasing the taxes or decreasing the government spending

Fiscal expansion - an increase in the budget deficit due to an increase in the government spending or to a decrease in taxes

Question 5

Monetary Policy

Answer 5

Monetary expansion - decreasing the interest rate by increasing the money supply

Monetary contraction (tightening) - an increase in the interest rate which is achieved through a decrease in the money supply

Interest rate ↓ => investment ↑ => demand and output ↓