IS-LM model 1

Question 1

An overview

Answer 1

*The IS–LM model is the modern formalization of Keynes’s theory. Purpose: determine national income for a given (fixed) price level. Explains short-run movements in income when prices are sticky and what causes the aggregate demand curve to shift. The model has two components. IS curve: equilibrium in the goods market (Investment–Saving). LM curve: equilibrium in the money market (Liquidity–Money). The interest rate links the two markets: Affects investment demand on the IS side and affects money demand on the LM side. The interaction of the IS and LM curves determines the position and slope of the aggregate demand curve,
and thus short-run national income.

Question 2

The Keynesian cross: planned expenditure

Answer 2

Keynes’s central idea: in the short run, total income is determined by the spending plans of households, firms, and government. If planned spending rises, firms sell more, produce more, and hire more workers. Recessions arise from insufficient spending. Actual expenditure = GDP. Planned expenditure = desired spending by households, firms, and government. Difference arises due to unplanned inventory investment.

Question 3

The Keynesian cross primitives

Answer 3

Planned expenditure in a closed economy= PE=C+I+G. Consumption depends on disposable income:
C=C(Y−T)

Question 4

The planned expenditure line

Answer 4

• Planned expenditure is an upward-sloping function of income, Y. PE=C(Y-T) + I + G. Higher income ￫higher consumption ￫higher planned expenditure. Slope of the PE line = MPC.
• With Iˉ and Gˉ fixed, only consumption changes when income changes. A £1 increase in income raises consumption by the marginal propensity to consume (MPC). The MPC governs how strongly planned expenditure responds to changes in income.

Question 5

Equilibrium condition

Answer 5

GDP (Y) is equal to total spending, or (aggregate) expenditure. Thus, the 45-degree line includes all the points on the graph where (planned) expenditure equals output. In equilibrium, planned expenditure needs to equal output. You should note that the planned expenditure line is flatter than the 45-degree line. This is because we do not consume all we earn (MPC<1)!

Question 6

Equilibrium income

Answer 6

The equilibrium point is the value of income at which the curves cross. We have two lines: PE=Y and PE=C+I+G. Combining yields > Y=C+I+G
This is our equation for GDP in a closed economy! Note that in equilibrium, PE equals Y.

Question 7

Adjustment to Equilibrium in the Keynesian Cross

Answer 7

Equilibrium requires Y=PE. When Y is not equal to PE, firms experience unplanned inventory changes. These inventory changes trigger adjustments in production, income, and expenditure. For instance output is above equilibrium (e.g., Y1​): Planned expenditure PE1​ is less than actual output Y1​. Firms sell less than they produce ￫ inventories rise unexpectedly. Firms respond by cutting production and laying off workers. Falling production reduces income ￫ reduces consumption ￫reduces Y, until Y=PE

Question 8

An increase in government purchases

Answer 8

Government purchases G are a component of planned expenditure. Increase in government purchases by ΔG: Shifts the planned-expenditure schedule upward by ΔG The economy moves from equilibrium A to equilibrium B. Note that the change in Y, ΔY, as a result of a change in G, is greater than the change in G, ΔG. Fiscal expansion has an amplified impact on national income.

Question 9

Government purchase multiplier

Answer 9

The government-purchases multiplier is ΔY/ΔG​>1 The increase in income ΔY exceeds the initial increase ΔG. Higher G raises income ￫ increases consumption ￫ further raises PE.

Question 10

A decrease in taxes

Answer 10

Taxes T are a component of planned expenditure but unlike government expenditure, taxes affect planned expenditure indirectly through consumption! When taxes decrease, shifts the planned-expenditure schedule upward by MPC×ΔT. The economy moves from equilibrium A to equilibrium B. Just as an increase in government purchases has a multiplied effect on income, so does a decrease in taxes.

Question 11

Tax multiplier

Answer 11

The tax multiplier is ΔY/ΔT>1 . It is in absolute values as taxes are leakages! The increase in income ΔY exceeds the initial increase MPC×ΔT given a tax cut. Lower T increases disposable income ￫ increases consumption ￫ raises PE ￫ increases income ￫ increases consumption ￫ further raises PE.