Macroeconomics Chapter 5: IS-LM Model Overview

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Questions and Answers

What was a significant consequence of the events of September 11, 2001?

Reduction in tax rates

Decrease in military spending

Increase in spending on defense and homeland security (correct)

Increase in international trade agreements

How does a fiscal consolidation affect the IS curve?

Shifts it to the left (correct)

Shifts it to the right

Has no effect

Makes it vertical

What is a potential result of a fiscal contraction on savings and investment?

Both savings and investment increase

Both savings and investment decrease

Savings increase and investment decreases (correct)

Savings decrease and investment increases

What effect does an increase in the federal funds rate have in the short run?

Decreases output and increases unemployment Signup and view all the answers

Which statement accurately reflects consumer behavior following a change in disposable income?

Consumers are likely to take time to adjust their consumption Signup and view all the answers

What is likely to happen to investment spending in firms following a change in sales?

Firms are likely to take time to adjust investment spending Signup and view all the answers

How does lower government deficit influence private saving and investment?

Lower deficits result in lower savings but higher investment Signup and view all the answers

What overall conclusion can be drawn from the interaction between fiscal policy and monetary policy adjustments?

Combined adjustments can lead to economic equilibrium without recession Signup and view all the answers

What does the I S relation in the goods market illustrate?

The relationship between investment, production, and the interest rate Signup and view all the answers

In the context of the I S-L M model, what does an upward-sloping Z curve indicate?

Increasing demand for goods as the output increases Signup and view all the answers

What was assumed about investment for the sake of simplicity in earlier chapters?

Investment is a constant value Signup and view all the answers

What is the effect of an increase in taxes on the I S curve?

It shifts the I S curve to the left. Signup and view all the answers

Why is the Z Z curve flatter than the 45-degree line?

Because of a less than one-for-one increase in demand with output Signup and view all the answers

What happens to equilibrium output when there is a monetary expansion?

Equilibrium output increases. Signup and view all the answers

What concept is central to understanding equilibrium in the goods market as described in the I S-L M model?

Equivalence between demand for goods and output Signup and view all the answers

How does a combined fiscal and monetary expansion affect the I S and L M curves?

I S shifts right and L M shifts down. Signup and view all the answers

What are Hicks and Hansen known for in economics?

Creating the I S-L M model Signup and view all the answers

What was the federal funds rate at the end of 2001, following macroeconomic policy responses?

2% Signup and view all the answers

What does the 45-degree line represent in the goods market model?

Equilibrium where output equals demand for goods Signup and view all the answers

What effect does an increase in output have on demand for goods, according to the I S-L M model?

Demand increases through its effects on consumption and investment Signup and view all the answers

What can be concluded about the U.S. economy during the recession of 2001?

The economy was triggered by declines in investment demand. Signup and view all the answers

What happens to the L M curve as a result of an increase in the interest rate during a monetary contraction?

It shifts to the left. Signup and view all the answers

What strategy is used to combat a recession when output is too low?

A combination of both fiscal and monetary policies. Signup and view all the answers

Which statement best describes the relationship between the I S curve and overall output?

The I S curve represents the relationship between interest rates and output. Signup and view all the answers

How does an increase in the interest rate affect the equilibrium level of output in the goods market?

It leads to a decrease in the equilibrium level of output. Signup and view all the answers

What is the relationship between the I S curve and the interest rate?

The I S curve is downward sloping with increasing interest rates. Signup and view all the answers

What effect does an increase in taxes have on the I S curve?

It shifts the I S curve to the left. Signup and view all the answers

In the I S–L M model, under what condition are both the goods and financial markets in equilibrium?

At the intersection of the I S and L M curves. Signup and view all the answers

What does a horizontal L M curve indicate in the financial market?

The money supply does not respond to changes in the interest rate. Signup and view all the answers

Which of the following characterizes the effect of factors that decrease demand in the goods market?

They shift the I S curve to the left. Signup and view all the answers

What is the primary purpose of analyzing changes in policy or exogenous variables in the I S–L M model?

To understand shifts in the I S curve and/or the L M curve. Signup and view all the answers

How does the demand for real money balances relate to real income and interest rates in the L M relation?

It increases with higher real income and decreases with higher interest rates. Signup and view all the answers

Study Notes

Macroeconomics Chapter 5: Goods and Financial Markets: The IS-LM Model

Chapter 5 examines goods and financial markets together, understanding how output and interest rates are determined short-term.
This framework is called the IS-LM model, developed by John Hicks and Alvin Hansen.
Previous chapters (3 and 4) individually addressed the goods market and financial markets.
Investment, a key component of the goods market, depends on both output (production/sales) and interest rates.
Equilibrium in the goods market is expressed as: Y = C(Y - T) + I(Y, i) + G. This is the IS relation.

5.1 The Goods Market and the IS Relation

In simplified models of Chapter 3, investment was assumed constant.
In reality, investment is dependent on production (Y) and the interest rate (i). Investment increases with higher output and decreases with higher interest rates: I = I(Y, i).
Equation (5.1) and (5.2) represent the mathematical relationship for investment (I) as a function of output and interest rate.
The IS curve is downward sloping, indicating that a higher interest rate leads to lower output.

5.2 Financial Markets and the LM Relation

Recall from Chapter 4: M = $YL(i). This equation describes money supply (M) is equal to income times the money demand function (L)
Dividing both sides of this equation by the price level (P) results in the LM relation: M/P = YL(i).
In equilibrium, the real money supply equals the real money demand. Real money demand depends on real income (Y) and the interest rate (i).

5.3 Putting the IS and LM Relations Together

The IS and LM relations jointly determine output, with equilibrium occurring at their intersection.
Any point on the IS curve corresponds to goods market equilibrium. Any point on the LM curve corresponds to financial markets equilibrium.

5.4 Using a Policy Mix

Monetary and fiscal policies are combined to manage the economy.
A decrease in G-T represents fiscal contraction (consolidation). An increase in G-T represents fiscal expansion.
A decrease in the interest rate (i) with an increase in money supply (M) is monetary expansion. An increase in i with decrease in M is monetary contraction (tightening).
Understanding how to combine these policies is crucial for influencing output and interest rates.

5.5 How Does the IS-LM Model Fit the Facts?

The IS-LM model is a short-run model.
Output adjustments take time, with consumers and firms adjusting consumption and investment, respectively, in response to changes in interest rates or disposable income.
Empirical evidence supports the model's predictions that an increase in the federal funds rate leads to lower output, higher unemployment, and minimal impact on the price level in the short run.

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Description

Chapter 5 explores the IS-LM model, a crucial framework for understanding the relationship between goods and financial markets. Learn how output and interest rates interact to determine economic equilibrium and the factors influencing investment decisions. This chapter builds on previous discussions of individual market components.