Ch 5: Goods and Financial Markets - The IS-LM Model

Flashcards covering key concepts, relations, policies, and models from the lecture on Goods and Financial Markets: The IS-LM Model.

IS-LM model

A macroeconomic framework developed by John Hicks and Alvin Hansen that looks at goods and financial markets together to understand how output and the interest rate are determined in the short run.

IS relation

Represents equilibrium in the goods market, where production (output) equals the demand for goods, considering that investment depends on both production and the interest rate. It is typically downward-sloping, meaning an increase in the interest rate leads to a decrease in output.

LM relation

Represents equilibrium in the financial markets, where the real money supply equals the real money demand, which depends on real income (output) and the interest rate. In a central bank interest rate targeting framework, it can be horizontal at the chosen interest rate.

Investment (I)

A component of aggregate demand which depends on production (or sales) and the interest rate.

ZZ line

Represents the demand for goods, which is an increasing function of output. It is upward-sloping but flatter than the 45-degree line, indicating that an increase in output leads to a less than one-for-one increase in demand.

IS curve

A downward-sloping curve indicating that equilibrium in the goods market implies an increase in the interest rate leads to a decrease in output. It shifts due to changes in factors impacting the demand for goods at a given interest rate.

LM curve

Represents equilibrium in financial markets. In a simplified model where the central bank chooses the interest rate, it is often represented as a horizontal line at the chosen interest rate.

Fiscal Policy

Government decisions regarding spending (G) and taxes (T) to influence the economy.

Fiscal Contraction (Fiscal Consolidation)

A macroeconomic policy involving a decrease in the government deficit (increase in taxes or decrease in government spending).

Fiscal Expansion

A macroeconomic policy involving an increase in the government deficit (decrease in taxes or increase in government spending).

Monetary Policy

Central bank decisions regarding the interest rate (and corresponding money supply adjustments) to influence the economy.

Monetary Expansion

A macroeconomic policy in which the central bank decreases the interest rate, leading to an increase in the money supply.

Monetary Contraction (Monetary Tightening)

A macroeconomic policy in which the central bank increases the interest rate, leading to a decrease in the money supply.

Monetary-Fiscal Policy Mix

The combined use of both monetary and fiscal policies to achieve specific macroeconomic objectives, such as stimulating output or reducing deficits.

Short-run output determination

In the short run, output is determined by the simultaneous equilibrium in both the goods market (IS relation) and the financial markets (LM relation).

Dynamics in IS-LM Model

Refers to the time-dependent adjustment processes within the economy, such as consumers adjusting consumption to disposable income, and firms adjusting investment and production to changes in sales or interest rates.