Question

Describe the automatic adjustments that will take place in the economy when the current position of the economy is "off" the IS curve. Describe the automatic adjustments that will take place in the economy when the current position of the economy is "off" the LM curve. Just use one case for each and carefully explain.

Answer 1

The IS-LM model

· The Interest Savings [IS] and Liquidity preference Money supply [LM], a Keynesian macroeconomic model depicts the interaction of the market for economic goods [IS] with the money market [LM].

· The intersection of the IS and LM curves gives the short run equilibrium between interest rates and output

· The three external variables in this model are investment, consumption and liquidity.

· The liquidity is determined by the size and velocity of money supply whereas the investment and consumption are determined by decisions of individuals in the market.

Analysis of IS and LM curves

· GDP is placed on the horizontal axis and increases towards the right and the interest rate is depicted in the vertical axis.

· The IS curve depicts he interest rates and the GDP a which investment equals savings. At lower interest rates, investment is higher and thus results in more GDP outcome which causes the IS curve to slope towards the right.

· The LM curve represents the income and interest rate at which money supply equals money demand. Higher income levels induces increased demand and induces higher interest rates to keep the money supply and liquidity in equilibrium and the LM curve slopes upward.

· When the IS and LM curves intersect, the point of intersection gives the equilibrium point of interest rate and output and thus represents the equilibrium case of money market and real economy.

Variations in the IS curve

· Higher demand for spending results in shifting the IS curve to the right which indicates, lower taxes, higher government spending and improvements in the business.

· Lower consumer responses in the market results in shifting the IS curve to the left

· The real world factors that causes variations in the IS curve are the autonomous factors that are unrelated to the interest rates like changes in consumer expenditure, changes in planned investment, government spending taxation, net exports etc.

· An increased government spending increases the aggregate demand in the economy and thus taxes are reduced to make more income available for spending.

· A higher level of output increases the demand for money which increases the interest rate and thus eliminates the excess demand for money

Variations in the LM curve

· When GDP goes up, the demand for money raises and equilibrium can only be restored only via higher interest rates which causes the LM curve to slope up.

· The higher money supply requires a higher demand for money and we need higher levels of GDP to generate this extra demand. Thus, the LM curve shifts out.

· Considering the supply side economics, higher prices raises the demand for money and the GDP must be now lower to maintain the equilibrium. Thus, the LM curve shifts in

· The real-world examples of variations in the LM curve are caused by changes in the money supply and autonomous changes in the money demand

· An increased money supply causes the interest rate to decline and leads to increase in the aggregate demand and investment patterns. Hence, the output also rises and the excess supply of money is eliminated.

Effect of Fiscal and Monetary policy in countering the variations

· Fiscal policy is set by the government and monetary policy by the central bank or the Federal reserve.

· At times of externalities like increased inflationary or deflationary situations, contractionary and expansionary fiscal and monetary policies can be implemented so as to bring back stability in the IS-LM curves and thus attain stability in the economy.

· Thus, both these policies will have higher impacts when there is a shift in the curve thus to bring back stability to the economy.