Macroeconomics: Short Run IS-LM Model and Monetary System

Vocabulary flashcards covering the monetary system, balance sheets, conventional and unconventional monetary policy, the IS-LM model, the zero lower bound, and risk premiums based on Macroeconomics Handout 3.

Financial Asset

A financial claim on another entity that generates a stream of benefits for the holder and represents a liability to the issuer.

Money (Liquidity)

The most liquid financial asset in an economy, defined by its ease of exchange for goods and services, which emerges simultaneously as an asset and a liability.

Central Bank (CB)

The monetary authority tasked with the conduct of monetary policy, possessing monopoly control over the creation of base money.

Monetary Financial Institutions (MFIs)

Financial intermediaries within the monetary system, including credit unions, commercial banks, and funds.

Base Money ($M0$)

High-powered money issued solely and directly by the central bank, consisting of physical currency and commercial bank reserves.

Commercial Bank Reserves

Interest-bearing deposits held by commercial banks at the central bank that are used to settle interbank transactions.

Broad Money ($M4$)

The total stock of money available to households and firms for settling transactions, comprising currency holdings ($\approx 2.8\%$) and bank deposits ($\approx 97.2\%$).

Fiat Money

Money that is not backed by any physical commodity and derives its transactional power from risklessness and public acceptance.

Policy Rate (Base Rate)

The interest rate set by the central bank for holding reserves, representing the benchmark cost of borrowing from and lending to the central bank.

Arbitrage

The practice of profiting by buying at a lower price in one market and selling at a higher price in another, which prevents interbank lending rates from falling below the central bank policy rate.

Transmission Lag

The delay between a central bank changing its policy rate and the effects being realized by households and firms in the real economy, typically lasting around a year.

LM (Monetary Policy) Curve

A horizontal relationship in the IS-LM framework showing that the central bank maintains a target policy interest rate ($i = \bar{i}$) regardless of output.

Zero Lower Bound (ZLB)

The barrier preventing nominal interest rates from falling meaningfully below zero, caused by agents having the option to hold physical cash rather than paying negative deposit rates.

Real Interest Rate ($r$)

The rate of return on saving and the cost of borrowing expressed in terms of physical goods rather than nominal currency units.

Fisher Equation

The formula approximating the real interest rate as the nominal interest rate minus expected inflation: $r \approx i - \pi^e$.

Quantitative Easing (QE)

An unconventional monetary policy in which the central bank buys non-money financial assets (such as long-term government bonds) directly from economic agents to create broad money and lower financing costs.

Risk Premium ($x$)

The additional spread charged above the policy rate to compensate a bank for borrower default risk, defined by the formula $x = \frac{p}{1-p}(1+i)$ where $p$ is the probability of bankruptcy.

Conventional Monetary Policy

A monetary policy approach that seeks to stabilize macroeconomic activity and output by adjusting the short-term policy interest rate.

Monetary Easing

An expansionary monetary policy operation achieved by lowering the policy interest rate to stimulate investment and spending.

Monetary Tightening

A contractionary monetary policy operation achieved by raising the policy interest rate to dampen investment and reduce economic activity.

Base Money ($M0$)

High-powered currency and commercial bank reserves created directly and solely by the central bank.

Broad Money ($M4$)

The total stock of purchasing power available to households and firms, consisting of physical currency holdings (\approx 2.8\%$) and bank deposits (\approx 97.2\%$) created primarily through commercial bank lending.

Commercial Bank Reserves

Interest-bearing deposit accounts held by commercial banks at the central bank, utilized to settle interbank payments and transactions.

Policy Rate (Base Rate)

The benchmark interest rate set by the central bank on commercial bank reserves, establishing the economy's terms for borrowing and lending funds with the monetary authority.

Transmission Lag

The delay between a central bank adjusting its policy rate and the real economy experiencing changes in expenditure and output, typically estimated to last around one year.

Zero Lower Bound (ZLB)

The economic barrier preventing nominal interest rates from falling meaningfully below zero, because economic agents can switch to holding physical currency rather than accepting negative deposit rates.

Quantitative Easing (QE)

An unconventional monetary policy operation where the central bank purchases non-money financial assets (primarily long-term government bonds) directly from economic agents to inject broad money and lower borrowing costs.

Arbitrage in Interbank Lending

The practice of profiting from price differences across markets that prevents interbank lending rates from falling below the central bank policy rate ($i$).

Fisher Equation (Approximation)

$r \approx i - \pi^e$, stating that the real interest rate ($r$) equals the nominal interest rate ($i$) minus expected inflation ($\pi^e$).

Fisher Equation (Exact Relationship)

$1 + r = \frac{P_t}{P_{t+1}^e}(1 + i)$, which equates the purchasing power of goods saved today with nominal interest earnings adjusted by expected future price levels.

Risk Premium Formula ($x$)

$x = \frac{p}{1 - p}(1 + i)$, where $p$ is the probability of borrower bankruptcy and $i$ is the policy rate, compensating banks for default risk.

Equilibrium Output Formula in Baseline IS-LM

$Y^{*}=\frac{1}{1-c_1-b_1}\left(c_0-c_1T+b_0-b_{i}\bar{i}+\bar{G}\right)$ , where $\bar{i}$ is the target policy rate fixed by the central bank.

IS Equilibrium Output with Expected Inflation

$Y^{*}=\frac{1}{1-c_1-b_1}\left(c_0-c_1T+b_0-b_{i}(\bar{i}-\pi^{e})+\bar{G}\right)$ , showing that higher expected inflation reduces the real borrowing cost and increases equilibrium output.

IS Equilibrium Output with Inflation and Risk Premium

$Y^{*}=\frac{1}{1-c_1-b_1}\left(c_0-c_1T+b_0-b_{i}(\bar{i}-\pi^{e}+x)+\bar{G}\right)$ , accounting for the risk premium $x$ charged by banks above the policy rate.

Graphical Representation of the LM Curve

A horizontal line at the target rate $i = \bar{i}$ in the $(Y, i)$ plane, demonstrating that the central bank supplies necessary liquidity to maintain its policy rate regardless of output.

Graphical Shift: Monetary Easing

The horizontal LM line shifts downward from $\bar{i}_0$ to $\bar{i}_1$, leading to a movement down along the downward-sloping IS curve and expanding output from $Y_0^*$ to $Y_1^*$.

Graphical Shift: Monetary Tightening

The horizontal LM line shifts upward from $\bar{i}_0$ to $\bar{i}_1$, leading to a movement up along the IS curve and contracting output from $Y_0^*$ to $Y_1^*$.

Graphical Shift: Rise in Expected Inflation ($\pi^e$)

The IS curve shifts rightward in the $(Y, i)$ space because the real borrowing rate ($r = i - \pi^e$) falls for any given nominal rate $i$, stimulating autonomous investment and boosting output.

Graphical Shift: Rise in Default Risk ($p$)

The IS curve shifts leftward in the $(Y, i)$ space because a higher default probability increases the risk premium $x$, raising borrowing costs ($i - \pi^e + x$) and reducing investment.

Graphical Impact of the Zero Lower Bound (ZLB)

The horizontal LM curve cannot shift below $i = 0$, restricting conventional interest rate cuts from shifting the equilibrium along the IS curve to counter severe negative shocks.

Graphical Shift: Countering a Positive Demand Shock

A positive shock to autonomous investment ($d_0$) shifts the IS curve rightward; the central bank counters this by shifting the LM curve upward to a higher policy rate $\bar{i}_1$ to return output to its medium-run level.