L20 - The IS-LM Model and Macroeconomic Policy Flashcards Preview

18ECA001 - Principles of Macroeconomics > L20 - The IS-LM Model and Macroeconomic Policy > Flashcards

Flashcards in L20 - The IS-LM Model and Macroeconomic Policy Deck (12):
1

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

- 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?

- 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?

- 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?

- 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?

- 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?

- 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?

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?

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?

- 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?

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?

- 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

What is the crowding-out effect?

- The term crowding-out effect refers to the lowering of investment spending whenver a rise in GDP is accompanied by a rise in the interest rate
- spending is crowed out by the rise in the interest rate that occurs when the quantity of money demanded rises because GDP rises