IS/LM Model and Money–Goods Market Interactions

A comprehensive set of flashcards covering the derivation and properties of the IS and LM curves, their shifts, the transmission mechanisms linking money and goods markets, liquidity-trap issues, crowding-out, Keynesian vs Monetarist perspectives, and the derivation of the Aggregate Demand curve from IS/LM analysis.

What does the IS/LM model simultaneously determine?

The equilibrium level of national income (Y) and the real interest rate (r) where both the goods and money markets are in balance.

What does the IS curve represent?

All combinations of interest rates and national income where planned injections equal planned withdrawals—i.e., equilibrium in the goods market.

Why is the IS curve downward-sloping?

Because higher interest rates reduce investment and raise saving, lowering equilibrium national income.

What causes a movement ALONG the IS curve?

A change in the interest rate, holding all other determinants of spending constant.

Name two factors that SHIFT the IS curve.

Changes in injections (I, G, X) or withdrawals (S, T, IM).

What does the LM curve represent?

All combinations of interest rates and national income where money demand equals money supply—i.e., equilibrium in the money market.

Why is the LM curve upward-sloping?

Because higher income raises money demand, which—given a fixed money supply—pushes up the interest rate needed for equilibrium.

What causes a movement ALONG the LM curve?

A change in national income, with the nominal money supply and real money demand function unchanged.

Give one factor that SHIFTS the LM curve.

A change in the money supply (MS) or in money demand unrelated to income (e.g., changes in liquidity preference).

Where is simultaneous macroeconomic equilibrium found in the IS/LM framework?

At the point where the IS and LM curves intersect.

What is the effect of a rise in injections (e.g., fiscal expansion) on the IS/LM equilibrium?

The IS curve shifts right, raising both national income and interest rates.

What is the effect of an increase in the money supply on the IS/LM equilibrium?

The LM curve shifts down/right, lowering interest rates and raising national income.

Outline Stage 1 of the monetary transmission mechanism.

An increase in the money supply lowers the interest rate (Money → r link).

Outline Stage 2 of the monetary transmission mechanism.

A lower interest rate stimulates investment spending (r → I link).

Outline Stage 3 of the monetary transmission mechanism.

Higher investment raises aggregate demand and national income through the multiplier (I → AD → Y).

What is a liquidity trap?

A situation in which interest rates are at or near a floor, so increases in the money supply are willingly held as idle balances and fail to reduce interest rates.

During a liquidity trap, which money-demand motive dominates?

The speculative motive; people hold money expecting bond prices to fall and rates to rise later.

What is likely to happen to the price level in a liquidity trap?

Downward pressure or deflation, because monetary policy is ineffective in stimulating spending.

How can fluctuating money demand affect interest rates?

Volatile shifts in money demand can cause substantial swings in interest rates even with a fixed money supply.

Define the ‘crowding-out’ effect.

When higher government-induced injections raise interest rates, private investment is partially or fully displaced.

List two factors that determine the degree of crowding out.

(1) Interest elasticity of money demand; (2) Interest sensitivity of investment demand.

How can monetary authorities offset crowding out caused by fiscal expansion?

By increasing the money supply to shift the LM curve down/right, keeping interest rates from rising.

In the Keynesian view, how elastic are the LM and IS curves?

LM is relatively elastic (flat); IS is relatively inelastic (steep).

In the Monetarist/New Classical view, how elastic are the LM and IS curves?

LM is relatively inelastic (steep); IS is relatively elastic (flat).

Under Keynesian slopes, which policy is more effective for raising income—fiscal or monetary?

Fiscal policy (IS shifts) because it raises Y with little effect on r when LM is flat.

Under Monetarist slopes, which policy is more effective for raising income—fiscal or monetary?

Monetary policy (LM shifts) because it raises Y with little change in r when IS is flat.

How is the Aggregate Demand (AD) curve derived from the IS/LM model?

A higher price level reduces the real money supply, shifting LM left, raising r, lowering Y along IS; plotting P against resulting Y yields the downward-sloping AD curve.

Why does a rise in the price level shift the LM curve left?

Because the real money supply (M/P) falls when P rises, decreasing liquidity and raising interest rates for any given income.

State the components of Aggregate Demand in the Keynesian model.

Consumption (C), Investment (I), Government expenditure (G), and Net exports (EX – IM).

What are ‘injections’ in macroeconomics?

Spending that adds to aggregate demand: Investment (I), Government expenditure (G), and Exports (X).

What are ‘withdrawals’ (or leakages)?

Income not spent on domestic output: Saving (S), Taxes (T), and Imports (IM).

Give an example of a policy aimed at increasing the money supply.

Quantitative Easing (QE), where the central bank purchases assets to inject liquidity.

What potential problem arises if investment demand is interest-inelastic?

Lower interest rates may have little effect on investment, weakening monetary policy’s impact on output.

How can unstable investment demand curves complicate policy?

Shifts in business confidence can offset the stimulus from lower interest rates, making outcomes unpredictable.

Describe the main message of IS/LM Summary Point 5 regarding curve slopes.

The steeper the IS and flatter the LM, the bigger the income rise and smaller the interest-rate rise after fiscal expansion.

Describe the main message of IS/LM Summary Point 6 regarding money supply changes.

Income gains from a higher money supply are larger when the IS curve is flat and the liquidity-preference curve is steep.

What does the term ‘transmission mechanism’ refer to in monetary economics?

The chain of effects through which changes in the money market influence the real economy and prices.