Lecture 17 - ISLM for Great Depression and Great Recession

Question 1

Recap of IS and LM curves

2. How can we find the equilibrium output (Ye) and interest rate (re)?

Answer 1

IS
Y = a + d + G* -bT* /(1-b) - f/(1-b) r

LM
Y = Ms/p/k + l/k r

2. Equate them. rearrange to find r (re)

then find equilibrium output Ye sub back into IS curve.

Question 2

Scenario 1:

ISLM - Short run effect of a rise global government expenditure.

a) What happens
b) What does size of shift depend on
c) and what does the size of impact depend on?

Answer 2

G shifts IS to right.

Size of shift depends on 1/1-b (MPC), multiplier effect

Size of impact of G increase depends on slope of LM (if LM steep=smaller change in Y)

Question 3

Scenario 2
ISLM - Short run effect of a global monetary tightening?

What happens, what does size of shift depend on, and what does the size of impact depend on

Answer 3

LM curve shifts left (Ms fall)

Size of shift depends on k (how sensitive demand for money is to Y)

Size of impact of LM fall depends on IS slope (if IS steep=smaller change in Y)

Question 4

Impact of a price change to ISLM, and how this is represented in ISLM and AD

Answer 4

ISLM-
A fall in price shifts LM curve right as real Ms increases.

So r falls and y increases.

AD
This price fall is demonstrated by a movement down in the AD curve. (shows how ISLM influences AD)

(Remember we showed earlier how demand for money influences AD in short run Y=Ms/kP)

Question 5

What explains the IS curve?

What explains the LM curve?

What explains AD curve?

Answer 5

Keynesian cross explains IS curve

Theory of liquidity preference explains LM curve

Then IS-LM explains the AD curve! (Y=Ms/kP , and for LM, shifts determined by Ms/p/k, a fall in price increase real money supply, LM and output right, shown by a downward AD curve)

Question 6

ISLM in the Great Depression
Main outcomes (2)

Answer 6

Large fall in demand - IS shift left.
Large fall in Ms (LM shift left)

Question 7

Why did demand fall? (2 for consumption, 2 for investment)

Answer 7

Consumption fell - wealth falls & uncertainty (due to mass unemployment from Wall Street crash)

Investment fell - collapse of banking system & uncertainty

Question 8

How did demand recover?

Answer 8

Roosevelt new deal - fiscal policy increased G (causing multiplier with households i.e the increased G increased household income allowing them to increase consumption)

Question 9

3 main Impacts of money supply fall.

Did each one contribute to the fall in demand during the GD?

Answer 9

Could have caused deflation (M=λP)

1.
Falling prices increasing consumption (wealth effect -real wealth increases)

Wealth was wiped out in GD so this couldnt happen.

2. If price change unexpected then wealth goes to creditors and away from debtors. (lenders do better as receive income which is now worth more and can buy more with reduced prices)

This reduced consumption as creditors have lower MPC than debtors, so demand fell.

3. Deflation also raises REAL interest rates if nominal rates do not fully adjust. and so investment falls, thus reducing demand(Fishers r=i-πe, if there is expected deflation, r increases as double negative makes positive r increase).

So the 2nd and 3rd points contributed to the fall in demand.

Question 10

How to show point 3: deflation causinig a rise in interest and thus investment graphically (pg 8)

Answer 10

Deflation means firms will undertake less investment.

r=i initially when we assume no inflation or deflation.

When deflation occurs, IS shifts downwards, r increases and i falls. Y also falls since less investment.

Question 11

Financial crisis analysis

Answer 11

Rise in uncertainty, wealth loss causing shift fall in IS.

Question 12

Severity was not as big as Great Depression due to policy.

Policy response to GFC (2)

Answer 12

Expansionary monetary policy - Money supply increased to provide liquidity to banking system

Exp fiscal policy