Question

a) Using the Keynesian cross model where the goods market equilibrium is determined and analyzed, graphically derive the IS curve, and explain each step. Explain what the equilibrium in the goods market implies for the IS curve, i.e., why is the IS curve downward sloping. Also, explain what causes shifts in the IS curve.

b) First, based on the analysis of the financial market equilibrium, graphically derive the LM curve. Explain what the LM curve is and explain in detail why it has its particular shape. Explain what causes shifts in the LM curve.

c) Suppose that the FED sells a large amount of bonds (say, treasury securities) through open market operations. Graphically illustrate and explain in detail what effect this operation will have on the LM curve and the IS curve. Also explain if it cause a shift in the IS and LM curve?

d) Suppose that the US government reduces government spending (G) to reduce the budget deficit (G-T>0). Graphically illustrate and explain in detail what effect this policy will have on the LM curve and the IS curve. Also explain if it cause a shift in the IS and LM curve?

Answer 1

A. GOODS MARKET EQUILIBRIUM : IS CURVE

For the goods market equilibrium, the interest rate is very important and is used to determine the level of investment. Rate of interest (ROI) and investment share an inverse relationship. So, as ROI increases , the investment falls and vice-versa.

So, changes in the ROI has an impact on the aggregate demand by changing the investment demanded component.

The IS curve can be derived through 3 graphs :

In the first graph the graph for interest rate and planned investment is plotted.

This graph portrays the relationship between the ROI and the planned investment. Since the curve is downward sloping it indicates an inverse relationship and the graph next to it shows the aggregate demand and level of income. So, as ROI falls , investment increase and AD increases and so does the Level of Income. This can be directly observed in the IS curve that has been derived from the other two graphs.

Why is IS curve downward sloping?

As observed above, reducing the ROI leads to an increase in the planned investment expenditure. This increase leads to an uoward shift in the aggregate demand curve and thus an increase in the national income. Hence, a low ROI indicates a higher a National Income and vice-versa. Since there exists an inverse relationship the curve is downward slopinng.

Shifts in IS curve

Changes in the autonomous expenditure leads to a shift in the IS curve.For example government and consumption expenditure.So, expenditure that does not depend on the ROI and income will cause a shift. For instance , the government will increase its expenditure for social welfare will shift the IS curve rightwards.

B. MONEY MARKET EQUILIBRIUM : LM CURVE

The LM curve can be obtained from the analysis of the money market. The demand for money is dependent on two factors the real income and real ROI.

So the LM curve can derived from the intersection of the different money demand curves and the supply as determined by the money authority. The LM curve portrays the relationship between the Level of Income and the ROI.

On the left side graph the family money demand curves are plotted and it can be seen that as ROI increases the Money demand increases. On the right hand side, the income level that relates to the different interest rates determined in the other graph ( money-market equilibrium) are plotted and the LM curve is determined.

Shape of the LM curve

The LM curve is an upward sloping curve because at higher levels of income, demand for money is higher and in the monet market equilibrium between the money demand and supply occurs at a higher interest rate. Hence, this implies ROI and level of income share a direct relationship. Hence, explaining its upward sloping shape.

Shifts

Factors that can shift the LM curve are changes in the money supplied which is fixed and change in the liquidity preference for a level of income mentioned.

C.

The decrease in money supply, with demand for money remaining unchanged, will lead to the increase in rate of interest. At a higher interest there will be less investment by businessmen. Less investment will cause aggregate demand and income to fall. This implies that with contraction in money supply LM curve will shift to the left. Hence the new equilibrium will be at Point B and ROI will increase to R2 and income will fall to Y1.

D.

Fall in Government expendi­ture results in the fall of aggregate demand for goods and services and thereby causes an inward or leftward shift in the IS curve.