Econ 102: Developing the IS-LM Model Quiz

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.