IS-LM closed economy

Question 1

What curve is used for goods and services?

Answer 1

IS curve (investment and savings)

Question 2

What does the IS curve show

Answer 2

set of combinations (Y,i) for which the goods market is in equilibrium

Question 3

What curve is for money and bonds

Answer 3

LM curve (liquidity- money)

Question 4

What does the LM show?

Answer 4

All combinations (Y,i) for which the financial market is in equilibrium.

Question 5

What does the IS-LM model show?

Answer 5

Short-run equilibrium in a closed economy

Question 6

What is meant by short run

Answer 6

Typically a year

Question 7

In the short run how is output determined?

Answer 7

Demand (Z)

Question 8

What is ignored in the short run

Answer 8

Supply constraints
assume firms are willing to supply any quantity at a given price.
Price is fixed

Question 9

Difference between medium run and short run

Answer 9

In the medium run prices and factors can adjust

Question 10

What do we know about interest rates in the goods market?

Answer 10

Interest rates affect output through investment

Question 11

What do we know about interest in the money market?

Answer 11

That output(income) affects the interest rate through money demand

Question 12

What is the formula for demand (expenditure) in the goods market?

Answer 12

𝑍 = 𝐶(𝑌 − 𝑇) + 𝐼(𝑌, 𝑖) + 𝐺 = 𝑐₀ + 𝑐₁(𝑌 − 𝑇) + 𝑏₀ + 𝑏₁𝑌 − 𝑏₂𝑖 + 𝐺

Question 13

What is the relationship between income and expenditure in the goods market?

Answer 13

𝑌 = 𝑍

Question 14

What condition defines equilibrium in the goods market?

Answer 14

Equilibrium occurs when 𝑌 = 𝑍

Question 15

Formula for equilibrium income (Y) using simultaneous equations

Answer 15

See iPad

Question 16

What shape is the IS curve and why

Answer 16

Downward sloping because higher i leads to lower Y

Question 17

Money demand as a function of income and the interest rate

Answer 17

MD=Y x L(i)
where L(i) is a decreasing function of i

Question 18

Equilibrium in money market

Answer 18

Where Money supply equals money demand

Question 19

Why does the money supply curve not slope upwards

Answer 19

Because the money supply is not fixed and the central bank chooses the interest rate and adjusts the money supply so as to achieve desired interest rate.

Question 20

Putting IS-LM together

Answer 20

*Both markets are in equilibrium
*Demand for expenditure on goods equals income
*Demand for money equals supply of money at the chosen rate of
interest

Question 21

What can be done with the IS-LM model

Answer 21

Use to look at short run effects of fiscal and monetary policy

Question 22

Fiscal policy

Answer 22

Changes in taxation or government spending

Question 23

Monetary policy

Answer 23

Changes to interest rates by central bank

Question 24

Steps for analyzing effects of change in policy or exogenous variables

Answer 24

1. does it shift the curve
2. what does this do to equilibrium output and interest rate
3. describe the effect in words

Question 25

Contractionary Fiscal policy

Answer 25

Decrease budget deficit Decrease government spending or transfers Increase taxes

Question 26

Budget deficit

Answer 26

G + Tr - T G= Government spending Tr= transfers T= taxes

Question 27

Expansionary fiscal policy

Answer 27

Increase in budget deficit Increase government spending Decrease taxes

Question 28

Why use expansionary fiscal policy?

Answer 28

Boosts aggregate demand Raises output (GDP) Reduces unemployment

Question 29

Why use contractionary fiscal policy

Answer 29

Slows down aggregate demand Cools inflation Prevents bubbles or fiscal imbalances

Question 30

What happens when taxes increase?

Answer 30

Consumption goes down due to less disposable income. If income = output, output lowers and this leads to lower investment.

Question 31

What is a balanced budget fiscal expansion?

Answer 31

It’s when government increases both spending (G) and taxes (T) by the same amount (∆), so the budget deficit remains unchanged.

Question 32

How does a balanced budget fiscal expansion affect output (Y)?

Answer 32

Output increases

Question 33

Why does output still rise even though taxes increase in a balanced budget expansion?

Answer 33

Because only a fraction (𝑐₁) of the tax increase reduces consumption, while full ∆ of G adds to demand.

Question 34

Contractionary monetary policy

Answer 34

Decrease money supply Increase interest rates. Fights inflation

Question 35

Expansionary money policy

Answer 35

Increase money supply Decrease interest rates

Question 36

Liquidity trap

Answer 36

A liquidity trap is interest rates are very low (near zero) and people prefer holding cash over investing or spending, making monetary policy ineffective

Question 37

Quantitative easing

Answer 37

Unconventional monetary policy used by central banks to stimulate the economy when interest rates are already very low or near zero.

Question 38

How does quantitative easing work?

Answer 38

1.The central bank creates money electronically. 2.It uses that money to buy financial assets — mainly government bonds and sometimes corporate bonds or other securities. 3.This injects liquidity into the financial system.

Question 39

The policy mix

Answer 39

Combining monetary an fiscal policy

Question 40

Why is a policy mix useful

Answer 40

Allows output level to be changed without too large a change in interest rate (vice versa)