7 Lecture Notes on IS-LM Model and Monetary Policy

These flashcards summarize key concepts and mechanisms from the IS-LM model and monetary policy, helping students prepare for exams.

What shifts the LM curve in the short run when money supply increases?

An increase in real money balances (M/P) because the price level (P) is fixed. This causes the real interest rate (r) to fall to restore money market equilibrium (M/P = L(i,Y)).

How does the IS

–LM model define the short run?

The price level (P) is fixed, so output (Y) and the real interest rate (r) adjust.

What happens to output in the long run after a monetary expansion?

Output returns to Y{FE} due to rising prices (P). In the long run, Y is fixed at Y{FE}, so P adjusts.

What is the effect of a monetary expansion in the short run?

It raises real balances (M/P, as P is fixed), causing r to fall (from M/P = L(i,Y)) and the LM curve to shift right, which in turn increases output (Y).

What causes the LM curve to shift back in the long run after a monetary expansion?

Rising prices (P) reduce real money balances (M/P). With output fixed at Y_{FE}, this reduction shifts the LM curve leftward to restore money market equilibrium (M/P = L(i,Y)).

How can investment increase while output remains constant?

By using contractionary fiscal policy (reduce government spending, shifting IS left) and expansionary monetary policy (increase money supply, shifting LM right). This lowers the real interest rate (r), leading to an increase in investment (I) through a movement along the IS curve, which helps keep output (Y) constant.

What does the LM curve depend on?

Real money supply (M/P), output (Y), and interest rates (i), as defined by the money market equilibrium equation (M/P = L(i,Y)).

In terms of the IS-LM model, what defines the long-run outcome?

The output will always return to full employment output (Y_{FE}).

What happens to interest rates after a monetary expansion in the short run?

Interest rates (r) fall because the increase in money supply (M), with fixed P, raises real money balances (M/P). This creates an excess supply of money, requiring a lower r to restore equilibrium in (M/P = L(i,Y)).

What does money neutrality mean in the long run?

Monetary changes do not affect real variables like output (Y) or real interest rates (r).

What is the relationship between investment and real interest rates?

Investment (I) tends to rise when real interest rates (r) fall. This represents a movement along the IS curve, not a shift of the curve itself.

Why reduce government spending for a policy mix aimed at increasing investment?

To shift the IS curve left, which allows the real interest rate (r) to fall (when combined with expansionary monetary policy) to stimulate investment (I) through a movement along the IS curve, while keeping output (Y) constant.

What does an increase in the money supply do to real balances in the short run?

It increases real balances (M/P) because the price level (P) is fixed, directly affecting the money market equilibrium (M/P = L(i,Y)).

How should you structure answers on monetary expansion effects?

Clearly separate effects into short run (where P is fixed, and Y and r adjust) and long run (where Y is fixed at Y_{FE} and P adjusts).

How does the LM curve behave when the central bank targets the interest rate?

The LM curve shifts in response to changes in money supply because the central bank makes money supply endogenous to maintain a constant target interest rate. For example, if output (Y) rises, increasing money demand (L(i,Y)), the central bank increases M to prevent i from rising.

What is a common mistake regarding IS shifts?

Confusing IS shifts with changes in monetary policy, which affect the LM curve.

Why use contractionary fiscal policy in a policy mix to increase investment?

To shift the IS curve left, enabling a lower real interest rate (r) to stimulate investment (I) via a movement along the IS curve, while keeping output (Y) at its full employment level (Y_{FE}) or a target.

What characterizes the long run in the IS-LM model?

Price flexibility and return to full-employment output (Y_{FE}).

Why do real money balances fall when Y > YFE?

When output (Y) exceeds full employment output (Y_{FE}), prices (P) begin to rise (as P adjusts in the long run). This increase in P reduces real money balances (M/P), shifting the LM curve leftward according to (M/P = L(i,Y)).

What rule requires changes in money supply to hold interest rates constant?

Interest-rate targeting.

Why might central banks prefer to keep real money supply constant when IS is unstable?

Keeping real money supply (M/P) constant (making money supply exogenous) means the LM curve is fixed, preventing output fluctuations from being amplified by monetary policy when faced with IS shocks.

When the LM curve is held constant, what happens to Y during IS shifts?

Y fluctuates due to IS shocks without policy amplification.

What do fixed prices in the short run imply for real balances?

They are sensitive to changes in money supply.

How does interest-rate targeting affect output during demand shocks?

It can amplify fluctuations due to the need for policy adjustments.

What happens under interest-rate targeting during demand shocks?

If a positive demand shock shifts IS right, output (Y) increases. Money demand (L(i,Y)) rises, so the central bank increases money supply (M) (making M endogenous) to prevent r from rising. This shifts the LM curve right, further amplifying the initial output increase.

What does IS instability force the central bank to decide?

Whether to target money supply (making it exogenous to fix LM) or the interest rate (making money supply endogenous to fix r).

Why does monetary policy not shift the IS curve?

Monetary policy (changes in money supply) affects the LM curve. The IS curve depends on fiscal policy and autonomous spending. Investment's response to interest rate changes is a movement along the IS curve, not a shift.

What indicates that the IS-LM model is primarily a representation of short-run economic activity?

The assumption of price rigidity (P fixed) in the short run.

In monetary expansion scenarios, what does the professor expect you to elaborate on?

The neutrality of money in the long run and its implications.

What do independent IS and LM shifts illustrate?

The interaction of fiscal and monetary policy on macroeconomic targets like output (Y) and interest rates (r).

What defines the short-run and long-run assumptions of the IS-LM model regarding fixed vs. adjusting variables?

Short run: P (price level) is fixed; Y (output) and r (real interest rate) adjust. Long run: Y (output) is fixed at Y_{FE} (full employment output); P (price level) adjusts.

What are the long-run implications of money neutrality in the IS-LM model?

In the long run, monetary changes do not result in permanent changes in real variables. This means Y (output) returns to Y_{FE}, r (real interest rate) returns to its original level, and the LM curve returns to its original real money balances position (M/P) as P (price level) adjusts.

What is the key equation representing money market equilibrium in the IS-LM model, and what variables are fixed/adjust in SR vs. LR?

The money market equilibrium is given by \dfrac{M}{P} = L(i, Y).

• In the short run: P is fixed. M adjusts LM, causing i and Y to re-equilibrate.

• In the long run: Y is fixed at Y{FE}. P adjusts to restore M/P to its original long-run equilibrium given Y{FE} and i.

How do we distinguish between movements along and shifts of the IS and LM curves?

• Changes in the real interest rate (r) lead to a movement along the IS curve.

• Changes in autonomous spending (e.g., government spending G or taxes T) cause the IS curve to shift.

• Changes in real money supply (M/P) or the central bank's interest rate target cause the LM curve to shift.

What is an effective paragraph structure for answering IS-LM exam questions to ensure full marks?

1. State the regime (Short Run: P fixed, Y and r adjust; Long Run: Y fixed at Y_{FE}, P adjusts).

2. Describe the initial shock.

3. Explain how and why curves shift (e.g., IS left due to G reduction).

4. Detail the immediate results on Y and $$