IS-LM Model Macroeconomics Assignment Help
Question # 1:
The Investment Savings-Liquidity preference Money IS-LM supply model majorly emphasize on the balance of the market of money and market of goods and services. It explains the association between the interest rates and the produced real output (Romer, 2000).
IS curve is for the market of goods and services
Y in the closed economy basically represents the production for the market of goods and it is equal to the demands of the goods in the market. Y is the sum of public spending and consumption. This relationship represents the IS curve. IS curve has a negative slope as it has a negative association between the production and the interest rate (Vroey, 2000).
IS-LM the curve for the money market
The curve LM shows the relationship between money and liquidity. In the closed economy, the equilibrium of demand and supply determines the interest rate. The LM curve has a positive slope as it has a positive association between the output produced and the rate of interest (Romer, 2000).
To any point of curves of LM and IS, in the corresponding market, the condition of equilibrium is true. The condition of equilibrium is when the two curves are and LM intersects at some point. Many factors have an impact on both IS and LM curves such as different economic policies. For example, If government spending increases commonly known as a fiscal policy as a result the IS curve will shifts to the right (King, 2000), as it is shown in the below graph (fig. 1.1). This is due to the increase in government spending which results in more output level for any interest rate. The IS curve shift may lead to the change in equilibrium point that is from point E1 to E2 with greater interest rates and also with the greater level of output (Goodhart, & Hofmann, 2005).
On the other hand, the increment in the supply of money while considering the monetory policy leads to shift the LM curve to the right as it is shown in the below graph (fig. 1.2). Rise in the supply of money results in the fall of interest rates (Colander, 2004).
If the central bank keeps the interest rates unchanged, the expected inflation rises and the real interest rate has fallen (Commonly we consider both expected inflation and inflation (and indeed often prices) as fixed in the short-run). The fall in the real interest results in the shift of LM curve to the right (it is due to the increase in the expected inflation); this result in the equivalent monetary stimulus, which raises output by using the usual channels … until inflation rises in order to end the short-run and the economy enters in the long-run (Woodford, 2011).
Question # 2:
It is essential to note that at what extent the monetary fiscal policy effects on the level of output. Transmission of changes in the supply of money has some basic and essential steps which can be run as follows. In its first step, the increment in the supply of money results in a decrease in the rate of interest. In its second step, the decline in the interest rate leads to an increment in the aggregate demand or total spending (Clarida, Gali, & Gertler, 2000). Consequently, the aggregate output modifies the changes in the aggregate demand. However, there are some of the links that do not work in the transmission process of changes in the supply of money (Woodford, 2001).
Firstly, the change in the interest rate is not because of change in the supply of money. Keynes discovered that liquidity trap may arise which stops the decline in the interest rate which is because of money supply. Liquidity trap is considered as a situation in which the people are ready to hold the given interest rate at whatever money is supplied to the market (Aghion, Bacchetta, & Banerjee, 2000). Whereas the money demand is perfectly elastic in this case and the LM curve will be straight horizontally. The increase in the supply of money does not have any impact on the LM curve and thus it does not impact on the interest rate. Consequently, the expansion in the supply of money in the operations of the open market will not cause any impact on total spending (both investment and consumption demand). Having the total demand unchanged, and there will be no change in the real output level (Woodford, 2001). As a result, in the liquidity trap situation, the expansion in the monetary policy in the operations of the open market does not have a large impact on the output level. Using the IS-LM model, in situation of horizontally straight LM curve, it is little bit difficult to illustrate graphically the impact of the expansion of money supply on the output level. However, the ineffectiveness of the expansion of money supply in the situation of liquidity trap can be easily explained by considering the LM curve to be relatively flat (it is as the proxy of the completely horizontal curve) which is caused by the liquidity trap condition (Aghion et al., 2000). As it is shown in the below graph (fig. 2.1), where the IS curve intersects the relatively horizontal curve LM at point E, determining the rate of interest r1 and the output level Y1. For instance, the country’s central bank does the expansion in the money supply which is equivalent to the EH horizontal distance that by moving LM curve to LM2 curve. In accordance to the given curve of IS, the point of equilibrium then shifts from point E to point O, the result in the slight decline in the rate of interest. Consequently, the real output hardly increases that impact on the recession conditions of the economy (Woodford, 2001).
Secondly, the factor which causes the ineffectiveness of the expansion in money supply occurs in the third step of the process of transmission commonly named as aggregate demand or spending that causes because of the changes in the interest rates. This condition occurs when there is an insignificant outcome of change in the interest rate especially on autonomous spending, the investment expenditures. The condition occurs when companies become so distrustful regarding the upcoming scenarios of generating revenues that they are unwilling to invest when there is a decline in the interest rates (Aghion et al., 2000). Consequently, the expansion in the supply of money that results to a decline in the rate of interest does not increase the real output. In accordance with these conditions of ineffectiveness of the expansion in money supply on the rate of interest, the IS curve is a straight line vertically as shown in the below graph (fig. 2.2) where the expansion in the supply of money equals to E1H does not increases the real output and stuck to the output level Y1 (Woodford, 2001).
Hence, I deny the statement that the impact of expansion in monetary policy on the level of output is very enormous when the demand for money is relatively insensitive to the changes in the rate of interest.
Question # 3:
Using the AS and AD framework, the long-run aggregate supply curve signifies the association between the level of price when the real GDP is equal to the potential GDP and the amount of real GDP supplied. In other words, it also represents the relationship between the price level determined the full employment classical model and the supplied quantity of real GDP (Carlin, & Soskice, 2005).
The determined output level at its full employment is not depend on the the level of price. However, the real wage rate is the only price that matters. Therefore, if the economy is operating on the path employment which is at its full, then the required production of the business depends positively on the K, A and Pop, and it does not rely on the price level. As a result, if we show the LAS curve graphically by having P on the vertical Y-axis and Y on the horizontal X-axis, then curve LAS will be perfectly inelastic (vertical) at the output level to its full employment (Dutt, 2006). The increase in K, A, and Pop results in the right shift of the LAS curve . In the below graph (fig. 3.1), the LAS curve is vertical due to the fact that the price level does not have any impact on potential GDP. All the price and wage rates on the LAS curve vary with a percentage so the real wage rate and prices are constant (Carlin, & Soskice, 2005).
In microeconomics, the short-run is the phase in which the real GDP either rises above or fallen down the potential GDP. In the short-run aggregate supply, the curve SAS represents the association between the level of price and the real GDP in the short-run when the rate of money wage and the price of other resources remain constant (Barro, 1994).
In determining the short-run aggregate supply curve by using the full employment classical model, by assuming that the wage (W) is fixed and the labour demand is used for determining the L. Consider, that the K, A and W are constant or fixed. And if P increases it will result in the decline of real wage rate and firms moves to the demand for labour and employ more labour. Having K and A constant and more of L, the business will supply more of the output Y. Correspondingly, the decline in the level of price results in the decrease in labour and the output level (Dutt, 2006).
The below graph (fig. 3.2), displays the short-run aggregate supply curve, an increase in the level of price along the SAS curve having the fixed wage rate and the other prices of resources leads to an increase in the supply of real GDP. Thus, the SAS curve is positive or has upward slope.
In the short run aggregate supply, the increase in potential GDP due to an increase in K and A leads to the shift in SAS and LAS curves to the right. If potential GDP increases due to an increase in Pop, it will lead to shifting the LAS curve to the right (Barro, 1994).
A rise in the nominal wage rate to which the K and A are fixed results in the shift of SAS curve but it do not has any impact on LAS, whereas the decrease in nominal wage rate increases the short-run aggregate supply and the curve SAS to the right, but it does not have an impact on LAS (Carlin, & Soskice, 2005).
