Is-Lm Model

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Questions to Lecture 7 – IS-LM model and Aggregate demand

1. Draw Keynesian cross as a comparison of planned and realized expenditures. What is the intercept of planned expenditure line? What is its slope? If government expenditures would be positive function of output, how would the Keynesian cross change?

We will go over this on the review session – easier to explain than on paper.

The intersect point represents the equilibrium output.

Black line – planned expenditures
Blue line – realized expenditures

If government expenditures would be positive function of output the blue line would shift up.

2. What are the tools of fiscal policy?
Fiscal policy has 3 tools:
1. Increase or decrease government expenditures
2. Cut or increase taxes
3. Increase or decrease transfer payments

3. Explain the mechanism of government expenditures multiplier – why is the effect on the output greater than initial increase in government expenditures? The government purchases multiplier is ∆Y/∆G

Initially, the increase in G causes an equal increase in Y, so ∆Y=∆G, But with increasing Y will be increasing C(Y-T)
→further ↑Y
→further ↑C
→further ↑Y
So government purchases multiplier will be greater than 1, it is same principal like with Bank’s creation of money when lending out.

4. Explain the mechanism of tax multiplier – why is the effect on the output greater than initial cut in taxes? Increase in taxes reduces consumer spending, which reduces equilibrium income. Firms reduce output, and income falls toward a new equilibrium. Tax multiplier is negative and smaller than G spending multiplier, because consumers save a fraction (1-MPC) of a tax cut so the initial boost is spending from a tax cut is smaller than from an equal increase in G Formula ∆Y=∆C+∆I+∆G

5. Compare tax and government expenditures multiplier.
Tax multiplier is smaller than G spending multiplier, because consumers save a fraction (1-MPC) of a tax cut, so the initial boost is spending from a tax cut is smaller than from an equal increase in G. Tax multiplier is negative while government expenditures multiplier is positive.

6. What will be the total effect on output in case that government leads a balanced budget – i.e. finances increased government expenditures by higher taxes? In this case, the spending multiplication effect would not happen. People would receive money through government expenditures but their demand would be suppressed by higher taxes. Still, there will be a boost in the demand, due to initial investment of government

7. How do you derive IS curve from Keynesian cross (picture)? The equation is Y = C(Y-T) + I (r) + G and it is a graph of all combination of r and Y that result in goods market equilibrium.

[pic]

8. How is interest rate determined within IS-LM model?
Interest rate is within IS-LM model determined as an intersection point.

It is determined on the money market – the interest rate that balances demand and supply of real money balances.

9. How can a central bank affect interest rate in the IS-LM model? Through changes in required reserves, open market operations and discount rate.

10. How do you derive LM curve from equilibrium on money market (picture)? The LM curve is a graph of all combination of r and Y that equate the supply and demand for real money balances. The equation is as follows: M/P = L (r, Y)

[pic]
This is a shift in LM curve – I was asking for derivation – can show it on the session.

11. What are IS shocks + give an example from the real world? IS shock are exogenous changes in the demand for goods and services. For example, change in business or consumer confidence or expectations. This will lead to change in...
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