Question

1. In the IS-LM model, analyze the effects of increased optimism among banks on all the endogenous variables (Y, r, I, S, C, T, L1, L2).

Answer 1

The IS-LM model, which stands for "investment-savings" (IS) and "liquidity preference-money supply" (LM) is a Keynesian macroeconomic model that shows how the market for economic goods (IS) interacts with the loanable funds market (LM) or money market. It is represented as a graph in which the IS and LM curves intersect to show the short-run equilibrium between interest rates and output.

• The IS-LM model describes how aggregate markets for real goods and financial markets interact to balance the rate of interest and total output in the macroeconomy.
• IS-LM was devised as a formal graphic representation of Keynesian economic theory.
• IS-LM can be used to describe how changes in market preferences alter the equilibrium levels of GDP and market interest rates, but the model lacks the precision and realism to be a useful prescription tool for economic policy.

  The IS-LM graph consists of two curves, IS and LM. Gross domestic product (GDP), or (Y), is placed on the horizontal axis, increasing to the right. The interest rate, or (i or R), makes up the vertical axis. The IS curve depicts the set of all levels of interest rates and output (GDP) at which total investment (I) equals total saving (S). At lower interest rates investment is higher, which translates into more total output (GDP) so the IS curve slopes downward and to the right. The LM curve depicts the set of all levels of income (GDP) and interest rates at which money supply equals money (liquidity) demand. The LM curve slopes upward because higher levels of income (GDP) induce increased demand to hold money balances for transactions, which requires a higher interest rate to keep money supply and liquidity demand in equilibrium.

  The intersection of the IS and LM curves shows the equilibrium point of interest rates and output when money markets and the real economy are in balance. Multiple scenarios or points in time may be represented by adding additional IS and LM curves. In some versions of the graph, curves display limited convexity or concavity. Shifts in the position and shape of the IS and LM curves, representing changing preferences for liquidity, investment, and consumption, alter the equilibrium levels of income and interest rates.

  Limitations of the IS-LM Model

  Many economists, including many Keynesians, object to the IS-LM model for its simplistic and unrealistic assumptions about the macroeconomy. In fact, Hicks later admitted model's flaws were fatal, and it was probably best used as "a classroom gadget, to be superseded, later on, by something better." Subsequent revisions have taken place for so-called "new" or "optimized" IS-LM frameworks.

  The model is a limited policy tool, as it cannot explain how tax or spending policies should be formulated with any specificity. This significantly limits its functional appeal. It has very little to say about inflation, rational expectations, or international markets, although later models do attempt to incorporate these ideas. The model also ignores the formation of capital and labor productivity.

  the investment–saving curve, the independent variable is the interest rate and the dependent variable is the level of income. (Note that economic graphs often place the independent variable—interest rate, in this example—on the vertical axis while the dependent variable is measured with the horizontal axis.) The IS curve is drawn as downward-sloping with the interest rate r on the vertical axis and GDP (gross domestic product: Y) on the horizontal axis. The initials IS stand for "Investment and Saving equilibrium" but since 1937 have been used to represent the locus of all equilibria where total spending (consumer spending + planned private investment + government purchases + net exports) equals an economy's total output (equivalent to real income, Y, or GDP). To keep the link with the historical meaning, the IS curve can be said to represent the equilibria where total private investment equals total saving, where the latter equals consumer saving plus government saving (the budget surplus) plus foreign saving (the trade surplus). In equilibrium, all spending is desired or planned; there is no unplanned inventory accumulation. The level of real GDP (Y) is determined along this line for each interest rate.

  Thus the IS curve is a locus of points of equilibrium in the "real" (non-financial) economy. Each point on the curve represents the equilibrium between saving broadly defined and investment.

  Given expectations about returns on fixed investment, every level of the real interest rate will generate a certain level of planned fixed investment and other interest-sensitive spending: lower interest rates encourage higher fixed investment and the like. Income is at the equilibrium level for a given interest rate when the saving that consumers and other economic participants choose to do out of this income equals investment (or, equivalently, when "leakages" from the circular flow equal "injections"). The multiplier effect of an increase in fixed investment resulting from a lower interest rate raises real GDP. This explains the downward slope of the IS curve. In summary, this line represents the causation from falling interest rates to rising planned fixed investment (etc.) to rising national income and output.

  The IS curve is defined by the equation

  Y = C ( Y − T ( Y ) ) + I ( r ) + G + N X ( Y ) , {\displaystyle Y=C\left({Y}-{T(Y)}\right)+I\left({r}\right)+G+NX(Y),}

  where Y represents income, C ( Y − T ( Y ) ) {\displaystyle C(Y-T(Y))} represents consumer spending as an increasing function of disposable income (income, Y, minus taxes, T(Y), which themselves depend positively on income), I ( r ) {\displaystyle I(r)} represents physical investment as a decreasing function of the real interest rate, G represents government spending, and NX(Y) represents net exports (exports minus imports) as a decreasing function of income (decreasing because imports are an increasing function of income)

• 

  IS curve represented by equilibrium in the money market and Keynesian cross diagram.