ISLM

Question 1

What does the ISLM model determine

Answer 1

• describes short run equilibrium in the goods market and the money market
• determines the interest rate (i) and income (Y)

Question 2

What are the key assumptions for ISLM

Answer 2

• the general price level (P) is constant (due to short run model)
• this implies that only quantities and the rate of interest can change to clear the market

Question 3

What does the phrase ‘to clear the market’

Answer 3

Bring it into equilibrium so there is no excess supply or demand

Question 4

How does the ISLM model reinterpret the national account identity (Y=C+I+G+NX)

Answer 4

• let Y be actual production or national income, what is produced and firms want to sell
• let C+I+G+NX be planned expenditure, what people are actually going to buy
• therefore equilibrium is when actual production equals planned expenditure

Question 5

Why does planned expenditure depend on the interest rate

Answer 5

• consumption (C): household spending decisions depends on interest rate levels as higher interest rates means higher savings, hence households save more and consume less
• investment (I): firms investment decisions depend on borrowing costs so investment drops on higher interest rates

Question 6

What does the investment savings curve show

Answer 6

Equilibrium for varying levels of interest

Question 7

What relationship between interest rate levels and output/national income does the IS curve show

Answer 7

It shows a negative correlation; higher interest rates result in lower output for reasons explained on another flashcard

Question 8

What does money demand depend on for LM curve

Answer 8

• value of transactions: higher income (Y) is associated to a higher level of transactions, hence more money needed
• preference for liquid assets: higher interest rates makes the prospect of holding money less appealing

Question 9

What does the liquidity money (LM) curve show

Answer 9

The interest rate that clears the money market for each level of income (when money supply equals money demand)

Question 10

Why does the LM curve slope up

Answer 10

• because as income increases, demand for money increases but money supply stays constant so interest rates rise
• the LM curve demonstrates the interest rate that clears the money market for each level of income

Question 11

How can ISLM model be used to derive the aggregate demand (AD) curve?

Answer 11

• the ISLM model gives interest rates for a given price level (P0)
• considering P1>P0, real money supply has decreased
• this shifts the LM curve to the left, resulting in higher interest rates and lower income
• this corresponds to two points on the AD curve (higher price level equals lower output)