Topic 2: IS-LM Model

Question 1

Assumptions

Answer 1

• Short run model - prices are fixed
• No full employment level of output

Question 2

RECAP: Total demand for goods and services

Answer 2

Z = C + I + G

In a closed economy as net exports: X - IM = 0

Question 3

Consumption function

Answer 3

C = Co + C1(Y-T)

Question 4

Investment Function

Answer 4

+ -
I = f( Y , i ) = bo + b1Y - b2i

b0 = autonomous investment
b1Y = sensitivity of I to Y
b2i = sensitivity of I to i

Question 5

Demand is now

Answer 5

Z = C(Y,T) + I(Y,i) + G

Question 6

Equilibrium output

Answer 6

Question 7

IS curves

Answer 7

Shows how changes in interest rate lead to movements along the IS curve

Question 8

IS curve

Answer 8

Shows for a given i, changes in other factors that affect Z lead to shifts in IS curve e.g changes in G and T

Question 9

Financial Markets: Money

Answer 9

Money (M) can be thought of as currency and deposit account

Question 10

Financial Markets: Bonds

Answer 10

Bonds pay a positive interest rate (i) and cannot be used for transactions

Question 11

Financial Markets: Money demand

Answer 11

Money demand: M^D/P = f(Y,i)
* higher Y → higher money demand
* higher i → lower money demand

Question 12

The endogenous supply of money in the economy

Answer 12

• Banks create money through loans
• central bank sets interest rates