Flashcards in L20 - The IS-LM Model and Macroeconomic Policy Deck (12):

1

## What does the IS-LM Model look like on a graph?

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- with Interest Rate (r) on the y-axis and Real GDP (Y)

- With the positive line of LM

- With the negative line of IS

- Equilibrium is at the point of interception

- Because the price level is constant, the real and nominal interest

rates are the same.

- This allows us to plot the IS and LM curves on the same chart, even though IS depends on the real rate of interest and LM on the money rate.

2

## How will Fiscal Policy cause shifts in the IS-LM model?

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- An increase in autonomous spending shifts the IS curve to the right and raises the equilibrium values of both GDP and the interest rate.

- Such as increase in government spending or a reduction in tax rate

that increases income and led to increase in consumption.

-A decrease does the reverse.

- For example, cut in government spending or increase in tax rate that

leads to a reduction in consumption.

- Same with other autonomous spendings: investments and exports.

3

## How will Monetary Policy cause shifts in the IS-LM model?

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- An increase in the real money supply or a reduction in real money demand shifts the LM curve rightwards,--> lowering the equilibrium interest rate while raising equilibrium GDP.

- A decrease in real money supply or an increase in real money demand does the reverse.

- The linkage is often referred to as the monetary transmission mechanism.

- It refers to the transmission of a monetary shock, such as change in the demand for or supply of money, into an effect on real spending or changes in interest rate.

4

## What do the different quadrants signify in the IS-LM model?

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- so in each of the 4 areas signifies disequilibrium in the spending and asset markets

5

## What does the top quadrant signify in the IS-LM model?

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- TOP: E < Y and M{d} < M{s}

- both GDP and the interest rate exceed their full equilibrium values so there is downwards pressure on the interest rate and GDP

- People will seek to substitute money for bonds which puts upwards pressure on the price of bonds hence downwards pressure on interest rates

- people will not be willing to buy all the output produced which puts downwards pressure of GDP

6

## What does the Bottom quadrant signify in the IS-LM model?

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- BOTTOM: E > Y and M{d} > M{s}

- both GDP and the interest rate are bellow their full equilibrium values so there is upwards pressure on the interest rate and GDP

- People will seek to substitute bonds for money which puts downwards pressure on the price of bonds and upwards pressure on the interest rate

- People will want to purchase more than is being produced which puts pressure on output to increase

7

## What does the Left quadrant signify in the IS-LM model?

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LEFT: E > Y and M{d} < M{s}

- GDP is below (below the IS) while the interest rate is above (above the LM) their equilibrium values

- This puts pressure GDP to rise and interest to fall

- People will seek to substitute money for bonds which puts upwards pressure on the price of bonds hence downwards pressure on interest rates

- People will want to purchase more than is being produced which puts pressure on output to increase

8

## What does the Right quadrant signify in the IS-LM model?

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RIGHT: E < Y and M{d} > M{s}

- GDP is above (above the IS) while interest rates are below (below the LM) their equilibrium values

- This puts pressure on GDP to fall and interest rates to rise

- People will seek to substitute bonds for money which puts downwards pressure on the price of bonds and upwards pressure on the interest rate

-people will not be willing to buy all the output produced which puts downwards pressure of GDP

9

## What can we learn for this shift variables of the IS-LM curve?

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- Fluctuations in exogenous spending flows cause changes in GDP and interest rates to be positively associated will each other, rising and falling together

- Fluctuations in the real money supply causes changes in GDP and changes in the interest rate to be negatively associated with each other, one rising while the other falls

10

## What is the basic linkages of the monetary transmission mechanism?

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The basic linkage is through the interest rate:

- A change in the demand for or supply of money leads to an attempt to

buy or sell bonds, which causes the interest rate to change.

- This in turn causes a change in investment, and in all other interest-sensitive spending.

- This in its turn changes aggregate spending. In the new equilibrium, both the interest rate and GDP are changed.

11

## What is the IS-LM multiplier?

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- The interest-constant multiplier (ΔY=ΔA/1-c) is shown by the horizontal shift in the IS curve in response to a shift in some component of exogenous spending.

- However in the present model the interest rate and hence investment is endogenous

- This leads to a now familiar story

-When GDP increases, the amount of money demanded increases.

- Given a consonant money supply this forces up the interest rate

- This in turn reduces investment spending and chokes off some of the expansion that would otherwise have occurred

- The resulting change in GDP is due to what may be called the interest variable multiplier

- The interest-variable IS-LM multiplier is always smaller than the interest-constant multiplier.

12