EGCP_L2

Question 1

LM Curve

Answer 1

Definition:
- The LM curve shows the positive relationship between the interest rate (i) and output (Y) that balances money supply and demand.
- It comes from the equilibrium condition M_s = p · L(i, Y).
- Increasing money supply shifts the LM curve down (lower i).

Question 2

IS Curve

Answer 2

Definition:
- The IS curve shows a negative relationship between output (Y) and interest rate (i), ensuring planned expenditures = actual expenditures.
- Core equation: Y = C(Y) + I(i) + G.
- A rightward shift indicates higher demand (e.g. more public spending).

Question 3

Money Market Equilibrium

Answer 3

Key Points:
- Money supply is set by the central bank; money demand depends on Y and i.
- At higher Y, money demand increases, pushing i up unless supply adjusts.
- The LM curve visualises how i must adjust for equilibrium at different Y levels.

Question 4

Increase in Public Spending

Answer 4

Effect:
- IS curve shifts right → output and interest rate both rise.
- May cause crowding out of private investment due to higher i.
- Historical example: German reunification led to a boom via public expenditures.

Question 5

Easing of Monetary Policy

Answer 5

Mechanism:
- Central bank increases money supply (or sets a lower target interest rate).
- LM curve shifts down → lower i, higher Y.
- Stimulates investment (I) and consumption (C).

Question 6

Declining Consumer Confidence

Answer 6

Consequences:
- IS curve shifts left as households consume less.
- Results in lower output and lower interest rate (in the short run).
- Possible counteractions: fiscal stimulus (shifts IS back right) or monetary easing (shifts LM down).

Question 7

Aggregate Demand Curve

Answer 7

Definition:
- Relates price level (p) to output (Y).
- Derived from how a change in p shifts the LM curve, thereby altering Y.
- The IS-LM framework in the short run gives rise to the AD curve when p is variable.

Question 8

Short-run Aggregate Supply (AS)

Answer 8

Key Points:
- Upward sloping due to sticky wages and contracts.
- Misconceptions about price changes can also cause deviations in output.
- In the short run, output is primarily determined by aggregate demand.

Question 9

Long-run Equilibrium Adjustment

Answer 9

Process:
- If output differs from the natural level (Y_n), prices gradually adjust.
- As prices change, the LM curve shifts, guiding Y back to Y_n.
- Downward wage/price adjustments can be slow and face resistance (e.g. Greece 2010–2016).

Question 10

Central Bank Instrument

Answer 10

Modern Practice:
- Central banks typically target the short-term interest rate, not the money supply.
- By stabilising i, they offset fluctuations in money demand.
- Examples: ECB sets the interbank rate (EONIA), Fed sets the federal funds rate.

Question 11

Long-term Interest Rates

Answer 11

Relationship:
- Long-term nominal interest rate i^L depends on expected future short-term rates plus a term premium.
- Central banks influence long-term rates via current and expected future short-term rates (and forward guidance).

Question 12

Taylor Rule & IS-MP Model

Answer 12

Modern Approach:
- Replaces LM with an MP (Monetary Policy) curve based on a Taylor rule: i responds systematically to inflation and output gap.
- Simplifies the trade-off analysis using a Phillips Curve to capture inflation-output dynamics.