Chapter 9: The IS-LM Model: A General Framework for Macroeconomic Analysis

Question 1

What are the three main market of the economy?

Answer 1

labor market

goods market

asset market

Question 2

What is mean by “full-employment level of employment”?

Answer 2

Equilibrium level of employment reached after wages and prices have fully adjusted.

Question 3

What is meant by “full-employment output”?

Answer 3

Amount of output produced when employment level. for the current level of capital stock and the production function.

Question 4

In what direction does the FE line shift, and for what reason, when there is an increase in…

labor supply

Answer 4

FE will shift to the right.

Equilibrium employment rises, raising full-employment output.

Question 5

In what direction does the FE line shift, and for what reason, when there is an increase in…

the capital stock

Answer 5

FE will shift to the right.

More output can be produced with the same amount of labor. In addition, increased capital may increase the MPN, which increases labor demand and equilibrium employment.

Question 6

Why does the savings curve slope up?

Answer 6

Because an increase in the real interest rate causes households to increase their desired level of savings.

Question 7

Why does the investment curve slope downward?

Answer 7

Because an increase in the real interest rate increases the user cost of capital, which reduces the desired capital stock and hence desired investment.

Question 8

For any level of output, the IS curve shows…

Answer 8

the real interest rate that clears the goods market.

Question 9

Why does the IS curve slope downward?

Answer 9

Because a rise in output increases desired national saving, thereby reducing the real interest rate that clears the goods market.

Question 10

An increase in the real interest rate results in a reduction of both…

Answer 10

Desired consumption, because people desire to save more when the real interest rate rises)

and

investment, because the use cost of capital increases when the real interest rate increases.

Question 11

For constant output, any change in the economy that reduces national savings relative to desired investment will _____________ the real interest rate that clears the goods market and thus shift the ______________ curve _________.

Answer 11

increases

IS curve

Up and to the right

Question 12

An increase in expected future output will shift the IS curve…

Why?

Answer 12

Shift:
Up and to the right.

Reason:
Desired savings falls (desired consumption rises), raising the real interest rate that clears the goods market.

Question 13

An decrease in expected future output will shift the IS curve…

Why?

Answer 13

Shift:
Down and the the left.

Reason:
Desired savings will increase (desired consumption falls), lowering the real interest rate that clears the goods market.

Question 14

An increase in gov. purchases will shift the IS curve…

Why?

Answer 14

Shift:
Up and to the right.

Reason:
Y < C + I + G
Desired savings fall (demand for goods rises), raising the real interest rate that clears the goods market.

Question 15

A decrease in gov. purchases will shift the IS curve…

Why?

Answer 15

Shift:
Down and to the left.

Reason:
Y > C + I + G
Desired savings will rise (demand for goods falls), lowering the real interest rate that clears the goods market.

Question 16

An increase in taxes will shift the IS curve…

Why?

Answer 16

Shift:
No change / down and to the left

Reason:
No change, if consumers take into account an offsetting future tax cut and do not change consumption (Ricardian Equivalence);

Down and to the left, if consumers don’t take into account a future tax cut and reduce desired consumption, increasing desired national savings and lowering the real interest rate that clears the goods market.
Y > C + I + G

Question 17

An increase in the expected future marginal product of capital, MPKf, will shift the IS curve…

Why?

Answer 17

Shift:
Up and to the right

Reason:
Desired investment increases, raising the real interest rate that clears the goods market.

Question 18

A decrease in the expected future marginal product of capital, MPKf, will shift the IS curve…

Why?

Answer 18

Shift:
Down and to the left

Reason:
Desired investment will fall, lowering the real interest rate that clears the goods market.

Question 19

An increase in the effective tax rate on capital will shift the IS curve…

Why?

Answer 19

Shift:
Down and to the left

Reason:
Desired investment will fall, lowering the real interest rate that clears the goods market.

Question 20

For a given level of output, any change that increases the aggregate demand for goods shifts the IS curve…

Answer 20

Y < C + I + G

Up and to the right, leading to higher real interest rates

Question 21

In what direction must rates move in order to clear the goods market in the case of excess aggregate demand?

Answer 21

Real interest rates must rise in order to lower desired consumption and investment.

Question 22

In what direction must rates move in order to clear the goods market in the case of excess aggregate supply?

Answer 22

Real interest rates must fall to increase desired consumption and investment.

Question 23

Two categories of assets.

Name them.

Answer 23

1. Monetary assets

2. Non-monetary assets.

Question 24

What is the relationship between the price of a non-monetary asset and the interest rate on that asset?

Answer 24

When the price of a non-monetary asset increases, the yield on that asset decreases.

When the price of a non-monetary asset decreases, the yield on that asset increases.

Question 25

For a given expected rate of inflation, movements in the nominal interest rate are matched by equal movements in the

Answer 25

real interest rate.

Question 26

For a given value of the expected rate of inflation, a higher real interest rate increases the relative attractiveness of ___________ assets and causes holders of wealth to demand __________ money.

Answer 26

non-monetary assets

less

Question 27

Why does the money demand curve slope downward?

Answer 27

The money demand curve slopes downward because for a given value of the expected rate of inflation, a higher real interest rate increases the relative attractiveness of non-monetary assets and causes holders of wealth to demand less money.

Question 28

What happens to the asset market equilibrium if output rises from 4000 to 5000?

Answer 28

People need to conduct more transactions, their real money demand increases at any real interest rate.

Question 29

How does an increase in the real interest rate eliminate the excess demand for money, and what causes this increase in the real interest rate?

Answer 29

The price of non-monetary assets and the interest they pay are negatively related. At an initial interest rate of say, 3%, the increase in output causes people to demand more money.

To satisfy their desire to hold more money, people will try to sell a portion of their non-monetary assets. This results in a decrease in the price of these assets, which means the real interest rates on these assets will rise.

Thus it is the public’s attempt to in crease its holdings of money by selling non-monetary assets that causes the real interest rate to rise.

Question 30

What happens to real money demand and real interest rates when the level of output the economy is producing increases?

Answer 30

When output increases, real money demand will increase, and the real interest rate will have to rise in order to bring the asset market back into equilibrium.

Question 31

Why does the LM curve slope upward?

Answer 31

Because increases in output, by raising real money demand, also raise the real interest rate on non-monetary assets needed to clear the asset market.

Question 32

An increase in the nominal money supply, M, will shift the LM curve…

Why?

Answer 32

Shift:
Down and to the right.

Reason:
Real money supply increases, lowering the real interest rate that clears the asset market (equates money supplied and money demanded)

Question 33

An increase in the price level, P, will shift the LM curve…

Why?

Answer 33

Shift:
Up and to the left

Reason:
Demand for money falls, lowering the real interest rate that clears the asset market.

Question 34

An increase in expected inflation will shift the LM curve…

Why?

Answer 34

Shift:
Down and to the right.

Reason:
Demand for money falls, lowering the real interest rate that clears the asset market.

Question 35

An increase in the nominal interest rate on money will shift the LM curve…

Why?

Answer 35

Shift:
Up and to the left.

Reason:
Demand for money increases, raising the real interest rate that clears the asset market.

Question 36

How does a decrease in the real interest rate eliminate the excess supply of money, and what causes this decrease in the real interest rate?

Answer 36

Holders of wealth have more money in their portfolios than they want to hold and, consequently, they have a smaller share of their wealth than they would like in non-monetary assets.

To eliminate this imbalance in their portfolios, holder’s of wealth will want to use some of their money to buy non-monetary assets

When holders of wealth as a group try to purchase non-monetary assets, the price of non-monetary assets is bid up and hence the real interest rate paid on these assets declines.

Question 37

What might cause the real money supply to increase?

Answer 37

In general, because real money supply equals M/P, it will increase whenever the nominal money supply, M, which is controlled by the central bank, grows more quickly than the price level, P.

change in M > change in P

Question 38

How will the real interest rate that clears the asset market change after an increase in money demand?

Answer 38

If holders of wealth want to hold more money, they will exchange non-monetary assets for money.

Increased sales of non-monetary assets will drive down their price and thus raise the real interest rate that they pay.

Question 39

How does an adverse supply shock work to shift the level of general equilibrium in the economy?

Describe the shock’s effect on:

a) labor
b) real wage
c) IS curve
d) LM curve
e) FE curve
f) price level

Answer 39

a) labor
- An adverse supply shock will reduce the level of output that can be produced at any given level of labor and capital. This means that the marginal product of labor is lower after the shock, and thus firms will employ less labor.

b) The real wage will fall because the productivity of workers has fallen.
c) The IS curve is not affected because an adverse supply shock does not change desired saving or investment. The temporary shock is a movement along the curve, and thus it does not shift.
d) The temporary supply shock has no direct effect on the demand or supply of money and thus doesn’t shift the LM curve.
e) The FE line will shift only to the degree that the full-employment output (Y-bar) changes.
f) When the FE line, the IS curve, and the LM curve don’t intersect at a common point, the LM curve shifts until it passes through the intersection of the FE line and IS curve. The shift in the LM curve is caused by changes in the price level, P, which change the real money supply, M/P, and thus affect the equilibrium of the asset market. Thus, an adverse supply shock will cause the price level to rise.