Lecture 4: The IS-LM Model

Question 1

What defines equilibrium in the goods market?

Answer 1

When production (Y) equals demand for goods (Z).

Question 2

What shape does the IS curve have, and why?

Answer 2

Downward sloping; as the interest rate increases, income (Y) decreases.

Question 3

What causes the IS curve to shift?

Answer 3

Changes in goods demand at a given interest rate (e.g., G or T changes).

Question 4

Does monetary policy shift the IS curve?

Answer 4

No, it affects the LM curve.

Question 5

What defines equilibrium in the financial market?

Answer 5

Real money supply equals real money demand.

Question 6

What are the two types of monetary policy control?

Answer 6

Money supply control and interest rate control.

Question 7

What causes the LM curve to shift?

Answer 7

Changes in the money supply or reserve ratio.

Question 8

Does fiscal policy shift the LM curve?

Answer 8

No, only monetary policy affects the LM curve.

Question 9

What is fiscal policy?

Answer 9

Implemented by the government, it influences the economy through taxation and government spending (e.g., increasing G or changing T to manage demand).

Question 10

What is monetary policy?

Answer 10

Conducted by the central bank, it influences the economy through interest rates and money supply (e.g., changing i or M to control inflation or stimulate growth).

Question 11

What is point A in the IS-LM model?

Answer 11

The intersection of IS and LM curves; equilibrium in both goods and financial markets.

Question 12

What is comparative statics in IS-LM?

Answer 12

Studying how Y and interest rate i adjust to changes in exogenous variables (e.g., G, T, M).

Question 13

What’s the difference between curve movement vs. shift?

Answer 13

Movement = change in interest/Y; shift = change in underlying variables (G, T, M).

Question 14

What does expansionary fiscal policy do to the IS curve?

Answer 14

Shifts it rightward.

Question 15

What’s the multiplier effect in fiscal policy?

Answer 15

GDP (Y) increases more than G due to a chain of spending.

Question 16

What limits expansionary fiscal policy?

Answer 16

Crowding out, time lags, leakages, Ricardian equivalence, budget constraints.

Question 17

What is Ricardian equivalence?

Answer 17

Households save increased income expecting future taxes, neutralizing fiscal stimulus.

Question 18

How does expansionary monetary policy affect LM?

Answer 18

Shifts LM curve downward.

Question 19

How does contractionary monetary policy affect LM?

Answer 19

Shifts LM curve upward.

Question 20

Does monetary policy shift IS?

Answer 20

No

Question 21

What is a liquidity trap?

Answer 21

A situation where more money doesn’t lower interest rates.

Question 22

Why is monetary policy ineffective in a liquidity trap?

Answer 22

Because people hoard cash instead of spending or investing, even when the central bank increases the money supply.

Question 23

How does an economy enter a liquidity trap?

Answer 23

Economic downturn causes falling demand and investment.

Central bank lowers interest rates to stimulate the economy.

If rates hit zero or near-zero, further cuts aren’t possible.

Expectations of deflation or pessimism lead people to save more, not spend.

Monetary policy loses effectiveness—this is the liquidity trap.

Question 24

Why is a liquidity trap problematic for policymakers?

Answer 24

It limits the central bank’s ability to boost the economy, forcing reliance on fiscal policy or non-traditional tools like quantitative easing.

Question 25

Name two criticisms of monetary policy.

Answer 25

Risk of inflation and loss of central bank credibility.

Question 26

Which curve does G or T affect?

Answer 26

IS curve.

Question 27

Which curve does money supply affect?

Answer 27

LM curve.

Question 28

Which policy causes crowding out?

Answer 28

Expansionary fiscal policy, especially under money supply control.

Question 29

What is crowding out in economics?

Answer 29

It's a situation where increased government spending leads to a reduction in private sector investment, usually due to higher interest rates.

Question 30

Under what conditions does crowding out occur?

Answer 30

When the government borrows more, it increases demand for loanable funds, which raises interest rates, making borrowing more expensive for private investors.

Question 31

How is crowding out shown in the IS-LM model?

Answer 31

Expansionary fiscal policy (↑G) shifts the IS curve to the right, but if the LM curve is steep or the central bank controls money supply, interest rates rise, reducing private investment.

Question 32

Does crowding out completely offset government spending?

Answer 32

Not always. It depends on economic conditions. In a recession or liquidity trap, crowding out may be minimal or nonexistent because interest rates don’t rise much.

Question 33

How can policymakers avoid or reduce crowding out?

Answer 33

Monetary accommodation (central bank keeps interest rates low) Targeted fiscal policy with high multiplier effects Stimulating the economy when there’s spare capacity

Question 34

What is the IS-LM model used for?

Answer 34

Analyzing short-run business cycles and GDP development.

Question 35

What is a limitation of the IS-LM model?

Answer 35

In the medium run, prices adjust and inflation/resource constraints matter.