Task M4

- Real interest rate

- Liquidity trap
- Fiscal Multiplier
- Crowding out on investment
- What is an IS relation? Why does it have a negative slope?

The IS relation shows us how income in the economy depends on the interest rate, through the
relationship between supply and demand in the goods market. The key channel here to think about, is
investment, in the simplified Keynesian model of AD,. Investment depends negatively on the interest
rate, firms are more willing to invest when interest rates are low, so high interest rates will mean
investment is lower and low interest rates will mean investment is higher. If you increase or decrease I in
the Keynesian model, you will increase or decrease Y.

- How to derive the IS relation?

The IS curve is derived from goods market equilibrium. The IS curve shows the combinations of levels of
income and interest at which goods market is in equilibrium, that is, at which aggregate demand equals
income.

- What is an LM relation? Why does it have a flat slope?

The model finds combinations of interest rates and output (GDP) such that the money market is in
equilibrium. This creates the LM curve. It has a flat slope because the interest rate is set by the Central
Bank and thus is given.

- What is the IS-LM model? Why is it a short-run model?

The IS-LM model appears as a graph that shows the intersection of goods and the money market. The IS
stands for Investment and Savings. The LM stands for Liquidity and Money. On the vertical axis of the
graph, ‘r’ represents the interest rate on government bonds. The IS-LM model attempts to explain a way
to keep the economy in balance through an equilibrium of money supply versus interest rates.

- What is the influence of fiscal or monetary policy on equilibrium income and the interest rate?

Fiscal influences IS part, Monetary policy influences LM. Fiscal expansion, increase GS and/or taxes
decrease, IS curve to the right. Contraction is vice versa. Monetary contraction, interest rate increases
(LM up). Monetary expansion, interest rate decreases (LM down).

- What happened in the financial crisis (2008-2009)? What special problems arise at very low,
zero interest rates?