Econ 102: Developing the IS-LM Model Quiz

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Questions and Answers

In the IS-LM model, what does the LM curve represent?

Equilibrium in the money market (correct)

Equilibrium in the goods market

Aggregate demand curve

Fiscal policy implications

Why is the LM curve upward sloping according to the text?

An increase in income raises money demand (correct)

An increase in exports raises money demand

An increase in interest rates raises money demand

An increase in government spending raises money supply

What does the equation M/P = L(r, Y) represent in the context of the economy?

Money demand as a function of interest rates and income (correct)

Quantity demanded for goods at a certain price level

Relationship between government spending and taxes

Investment demand curve

How does an increase in income impact the LM curve?

Shifts the LM curve to the right Signup and view all the answers

What is the role of interest rates in restoring equilibrium in the money market?

Interest rates must rise to restore equilibrium in the money market Signup and view all the answers

How is equilibrium defined in the IS-LM model?

Equilibrium in the goods market and money market Signup and view all the answers

What characterizes the short run in the IS-LM model?

Sticky prices and demand affecting supply Signup and view all the answers

Which component is part of planned expenditure in the Keynesian Cross model?

Government spending Signup and view all the answers

Why does an increase in taxes lead to a reduction in income in the short run?

It decreases consumption and planned expenditure Signup and view all the answers

What happens to output and income when firms face an unplanned inventory buildup?

Output decreases and income falls Signup and view all the answers

What does the tax multiplier indicate when it comes to fiscal policy?

Tax increases reduce consumption and income Signup and view all the answers

How does the IS-LM model determine income and interest rates in the short run?

By keeping prices fixed and analyzing the impact of changes in fiscal and monetary policy Signup and view all the answers

What motivates firms to increase investment spending in the IS-LM model?

A fall in the interest rate Signup and view all the answers

In the IS-LM model, what is the consequence of a fall in the interest rate on total planned spending (PE)?

PE increases Signup and view all the answers

How does a fall in the interest rate affect the equilibrium output (Y) in the goods market according to the IS-LM model?

Output increases Signup and view all the answers

What does the IS curve represent in the IS-LM model?

Relationship between interest rate and output Signup and view all the answers

Which curve helps us understand the relationship between interest rate and income through the good markets in the IS-LM model?

LM curve Signup and view all the answers

What is needed to accurately determine both interest rate and income in the IS-LM model?

Multiple equations Signup and view all the answers

Study Notes

The LM Curve

Represents the combinations of interest rates and income levels that result in equilibrium in the money market.
Upward sloping because as income rises, the demand for money increases, leading to a higher equilibrium interest rate.

Money Market Equilibrium

The equation M/P = L(r, Y) describes the equilibrium in the money market.
M represents the money supply, P is the price level, L is the demand for money, r is the interest rate, and Y is income.
An increase in income shifts the LM curve to the right because a higher income level increases money demand.

Interest Rates and Equilibrium

Interest rates play a role in restoring equilibrium in the money market by adjusting the demand for money.
When the demand for money exceeds the supply, interest rates rise, discouraging borrowing and reducing the demand for money until equilibrium is reached.
Conversely, when the supply of money exceeds demand, interest rates fall, encouraging borrowing and increasing the demand for money until equilibrium is restored.

IS-LM Model Equilibrium

Equilibrium in the IS-LM model occurs when the IS and LM curves intersect.
This intersection represents a combination of interest rates and income that simultaneously equilibrates the goods market and the money market.

The Short Run in IS-LM

Characterized by fixed prices and wages, with firms adjusting production levels to meet demand.

Components of Planned Expenditure

Planned expenditure in the Keynesian Cross model includes consumption (C), investment (I), government spending (G), and net exports (NX).

Tax Multiplier and Income

An increase in taxes leads to a reduction in income in the short run because it reduces disposable income, leading to a decrease in consumption.
The tax multiplier indicates the change in income resulting from a change in taxes.

Unplanned Inventory Buildup

Occurs when actual expenditure falls short of planned expenditure.
This leads to a decrease in output and income as firms reduce production to avoid further inventory accumulation.

IS-LM and Income & Interest Rates

The IS-LM model determines income and interest rates in the short run by considering the interplay between the goods market and the money market.
The IS curve represents the equilibrium in the goods market, and the LM curve represents the equilibrium in the money market.

Investment Spending in IS-LM

Firms are motivated to increase investment spending in the IS-LM model by lower interest rates.
Lower interest rates make borrowing cheaper, encouraging firms to undertake more investment projects.

Fall in Interest Rates in IS-LM

A fall in the interest rate leads to an increase in total planned spending (PE) in the IS-LM model.
This is because lower interest rates reduce the cost of borrowing, encouraging investment and consumption.

Interest Rates and Equilibrium Output

In the IS-LM model, a fall in the interest rate shifts the IS curve to the right.
This leads to an increase in equilibrium output (Y) in the goods market.

IS Curve Representation

The IS curve represents the combinations of interest rates and income levels that result in equilibrium in the goods market.

Understanding Interest Rate and Income Relationship

The IS curve helps us understand the relationship between interest rate and income through the goods markets.
It shows how changes in interest rates affect the level of planned spending and, consequently, the equilibrium level of income.

Determining Income & Interest Rates

To accurately determine both interest rate and income in the IS-LM model, both the IS and LM curves are needed.
This is because the model simultaneously considers equilibrium in both the goods market and the money market, where the interest rate plays a crucial role in both.

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Description

Test your knowledge on developing the IS-LM model, understanding the difference between the long run and short run, and how the Keynesian cross incorporates mathematical models in economics.