IS-LM model 4

Question 1

Monetary policy and AD

Answer 1

The central bank can increase aggregate demand through expansionary monetary policy. At constant prices, ↑ M ⇒ LM shifts down/left ⇒ ↓r ⇒ ↑I ⇒ ↑Y.

Question 2

Fiscal policy and AD

Answer 2

Government can increase aggregate demand through expansionary fiscal policy. At constant prices, ↑ G or ↓ T ⇒ IS shifts up/right ⇒ ↑Y ⇒ (↑r ⇒ ↓I ⇒ ↓Y). Where the response from increased interest is the crowding out of investment.

Question 3

The IS-LM model in the SR

Answer 3

Output is below the natural level Ỹ. With prices sticky, the economy is temporarily stuck with low income and high unemployment.

Question 4

The IS-LM model in the LR

Answer 4

*Weak demand for goods and services exerts downward pressure on prices. As P falls, M/P ↑ ⇒ LM shifts right. The economy moves along the IS curve toward higher income. At the new price level P2, equilibrium is at point C, where: Y = Ỹ.

Question 5

IS-LM equations

Answer 5

IS equation (goods market): Y = C(Y – T) + I(r) + G. LM equation (money market): M/P = L(r, Y)

Question 6

Keynesian assumptions (Short Run)

Answer 6

Prices are sticky: P = P. With P fixed, Y and r adjust to satisfy IS and LM. Output can deviate from its natural level Ỹ

Question 7

Classical assumption (Long run)

Answer 7

Output always returns to its natural level: Y = Ỹ. With Y fixed, P and r adjust to satisfy IS and LM. Prices are fully flexible

Question 8

Keynesian (Short run)

Answer 8

Best describes short-run fluctuations. Prices and wages adjust slowly. Output is demand-determined. The economy can be stuck away from Ỹ due to shocks or weak demand. IS–LM with P fixed explains recessions, recoveries, and policy stabilization.

Question 9

Classical (Long run)

Answer 9

Best describes the long-run equilibrium. Prices fully adjust to clear markets. Output returns to its natural (full-employment) level. IS–LM with Y = Ỹ determines the long-run price level. Basis for long-run analyses in earlier topics (production, labour markets, money).

Question 10

Exogenous variables

Answer 10

Exogenous variables in the IS-LM model are those determined outside the model, which influence the equilibrium in the goods and money markets but are not themselves affected by the model’s endogenous outcomes.

Question 11

Endogenous variables

Answer 11

In the IS-LM model, endogenous variables are those determined by the interaction of the goods market and money market within the model, primarily the interest rate (i) and the national income/output (Y).