IS-LM model 3

Question 1

Monetary policy- Shifts in the LM curve

Answer 1

For any income level Y, the LM curve shows the level of interest rate r that clears the money market. It is drawn for a given monetary policy: money supply Mˉ , and fixed prices Pˉ. Suppose the Fed reduces the money supply. With P fixed in the short run, real money balances fall. For any level of income Y, money demand is unchanged. With a lower money supply, the equilibrium interest rate must rise to restore equilibrium. Therefore, a decrease in M shifts the LM curve upward.

Question 2

IS-LM bigger picture

Answer 2

The Keynesian cross explains the IS curve, and the theory of liquidity preference explains the LM curve. The IS and LM curves together form the IS–LM model, which explains the aggregate demand curve. The aggregate demand curve in turn is part of the model of aggregate supply and aggregate demand, which economists use to explain short-run fluctuations in economic activity.

Question 3

Fiscal Policy- Increase in G

Answer 3

An increase in G increases income by ΔG × (1/(1-MPC)) at a given interest rate. The IS curve shifts by this amount. As income increases, liquidity demand increases. At constant M, the interest rate increases. Increased interest rate reduces investment demand. Investment is crowded out! As a result, some of the expansionary effect of the increase in government purchases is partially offset. Income increases less than what the Keynesian cross predicts.

Question 4

Fiscal policy- Tax cut

Answer 4

A decrease in T increases income by ΔT × (-MPC/(1-MPC)) at a given interest rate (recall it is a tax cut so ΔT < 0). The IS curve shifts by this amount. As income increases, liquidity demand increases. At constant M, the interest rate increases. Increased interest rate reduces investment demand. Investment is crowded out! As a result, some of the expansionary effect of the tax cut is partially offset. Income increases less than what the Keynesian cross predicts

Question 5

Monetary policy- Monetary growth

Answer 5

An increase in M at unchanged liquidity demand results in agents buying bonds, which increases bond prices reducing the interest rate. As the interest rate decreases, investment demand increases causing planned expenditure and income to increase. As income increases, liquidity demand increases partially offsetting the fall in interest.
The interest rate does not fall as much as the money market predicts

Question 6

Fiscal vs monetary policy

Answer 6

In the IS-LM model, both monetary and fiscal variables are exogenous (M, G, T), and they are simply policy measures. Whenever there is a change in government’s policy (e.g., fiscal policy), the central bank may respond, because as we have seen, they are interdependent (e.g., changes in T affect r through Y and changes in M affect Y through r). Given an Increase in T, the Central Bank May:
1. Hold M constant
2. Hold r constant
3. Hold Y constant
In each case, the effect of the fiscal policy will be different!

Question 7

IS Shocks: Changes in the Demand for Goods and Services

Answer 7

Investment pessimism (animal spirits): Firms reduce planned investment at every interest rate. ⇒ IS shifts left ⇒ Y ↓, r ↓.
Consumer optimism (confidence shock): Higher current consumption (lower desired saving). ⇒ IS shifts right ⇒ Y ↑, r ↑.

Question 8

LM Shocks: Changes in Money Demand

Answer 8

Higher money demand (e.g., credit card restrictions): At every Y, more money is demanded to transact. ⇒ LM shifts up/left ⇒ r ↑, Y ↓.

Question 9

Policy implications

Answer 9

Shocks to IS or LM curves cause fluctuations in Y and r. Stabilization policy (fiscal or monetary) can offset these shocks—if policymakers act quickly and accurately.

Question 10

Using IS-LM model to derive AD

Answer 10

The money supply M is fixed by the central bank. A higher price level P reduces real money balances. Lower real money balances shift the LM curve upward. A higher interest rate reduces investment I(r), which lowers equilibrium income Y. When P rises: LM ↑ ⇒ r ↑ ⇒ I ↓ ⇒ Y ↓. Plotting all (P, Y) pairs associated with IS-LM equilibrium gives the downward-sloping AD curve.