L5-6: IS-MP Model Flashcards

Flashcards based on lecture notes about the IS-MP Model

What does the IS-MP model study?

Simultaneous equilibrium in the goods and money market; how income and interest rates are jointly determined.

What factors shift the IS curve?

Government expenditure (G), taxes (T), and expectations of future income growth.

What does the slope of the IS schedule reflect?

The slope reflects how sensitive aggregate demand (spending) is to changes in interest rates. A steeper slope indicates that demand is less sensitive, while a flatter slope suggests greater sensitivity.

What does a change in monetary policy imply in the IS-MP model?

A change in monetary policy implies the government chooses a lower interest rate for any level of income, causing a rightward shift of the MP curve.

What does the MP schedule represent?

The MP schedule represents the relationship between the nominal interest rate and the level of output in the economy, reflecting monetary policy decisions.

According to the IS-MP model, when is the central bank likely to use higher interest rates?

The central bank is likely to use higher interest rates when output is high. This is done to combat inflation and stabilize the economy by reducing aggregate demand.

What is the crowding out effect in the context of fiscal expansion?

The higher interest rate discourages private investment, blunting the expansionary impact of a rise in G.

This phenomenon occurs when increased government spending leads to higher interest rates, which then reduces private sector investment.

How can public spending "crowd in" private investment?

Public investment, for example, through improving infrastructure, can enhance the productivity of private investments. By making it more profitable for businesses to invest, thereby increasing overall economic activity.

How does a looser monetary policy affect the MP curve?

A looser monetary policy causes the MP curve to shift right/downward, implying a lower interest rate for any level of income. This shift reflects the central bank's intent to stimulate the economy by lowering the cost of borrowing, encouraging spending and investment.

What happens when money demand changes in the IS-MP model?

The central bank changes money supply to accommodate the changes in money demand, keeping interest rates stable depending on the level of output.

What factors does the fiscal multiplier depend on?

1. Induced Purchases: The extent to which the initial fiscal stimulus (gov spending) leads to additional spending in the economy.

2. Leakage Abroad: The portion of the stimulus that is spent on imports, reducing the domestic impact.

3. Interest Rate Effects: If the stimulus causes interest rates to rise, it becomes more expensive for businesses to borrow money and invest

4. Debt Sustainability: Concerns about increasing government debt, which may reduce consumer and business confidence, undermining the multiplier effect.

What is Ricardian equivalence?

Rational consumers will lower their spending today (increase their savings) to ensure that they can pay those higher taxes in the future.

What are the limitations to fully effective fiscal and monetary policies?

Limitations include time lags in policy implementation, uncertainty about economic conditions, and constraints from government debt levels and external factors.

What is the goal of spending management with fiscal and monetary policies?

Using government spending, taxes, and controlling the amount of money in the economy to keep things from getting too hot (inflation) or too cold (recession).

What is the fiscal multiplier

The fiscal multiplier is a measure of how much economic activity is generated from an increase in government spending or a decrease in taxes, indicating the effectiveness of fiscal policy in stimulating the economy.