Macroeconomics: Inflation and Aggregate Demand Essay

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Macroeconomics

IS-LM Basics

A) The IS curve slopes downward and to the right.
B) The LM curve slopes upward and to the right.
C) The slope of the LM curve depends on the interest sensitivity of money demand. An elastic money demand function caused the LM curve to be relatively flat. An inelastic money demand function caused the LM curve to be steep.
D) The slope of the IS curve depends on the slope of the investment function. If investment is highly interest elastic, then the IS curve is relatively flat. If investment is not highly interest elastic, then the IS curve is very steep.
E) The quantity of money and shifts in money demand at given levels of income and interest rates will shift the position of the LM curve.
F) Government expenditures, tax increases, and autonomous investment expenditures shift the position of the IS curve.

Transaction Demand – Money is a medium of exchange and individuals hold money for use in transactions. Money bridges the gap between the receipt of income and eventual expenditures.

Precautionary Demand – Keynes believed that, in addition to the money people held for planned transactions, more money was held for unexpected expenditures that were at times necessary. Money would be held for emergencies, to pay unexpected medical bills or repair bills of various types.

Speculative Demand – Money held by those speculating on future changes in the interest rate and the relationship the interest rate had with the level of bond prices.

Keynes’ Money Demand Function

Md = Co + (C1 x Y) + (C2 x R) , C1 * 0 , C2 * 0

A rise in income increases money demand, a rise in the interest rate leads to a fill in money demand.
Md = Money Demand
Y = Income
R = Interest Rate
C = Parameter (Holds no economic value)

Transaction Demand - Dependent positively on the level of income.
Precautionary Demand - Keynes believed that the amount of money held for this purpose depends positively on income. The interest rate might be a factor if people tended to economize on the amount of money held for the precautionary motive as interest rates rose.

Speculative Demand - The money also held by those speculating on future changes in the relationship with the interest rate and the level of bond prices. If interest rates were expected to move in such a way as to cause capital losses on bonds, money would be held by those individuals. The speculative demand for money was negatively related to the interest rate.

A) Decrease in government spending:

Y decrease because Y = C + I + G (If G goes up so must Y.) The decrease in government spending shifts the IS schedule out to the left to a position IS1. The equilibrium level of income decreases. The equilibrium level of the interest rate also decreases. Lower interest rate serves to increase investment (I), thereby leading to increase in y. Money supply goes up, output goes up, and interest rates go down.

b) Autonomous increase in investment spending:

I increases because Y = C + I + G (If I goes up so must Y.) The autonomous increase in investment spending shifts the IS schedule to the right from ISo to IS1. Income increases from Y0 to Y1. The interest rate increases from Ro to R1. Income increases because investment demand at the initial interest rate from Io to I’1. As income increases, consumption spending increases. The interest rate increase is also a result from the income increase. The increase in income causes money demand to go up and interest rates to increase.

C) Increase in money stock.

The increase in money stock shifts the LM schedule to the right, LM to LM1. As a result, the interest rate falls from Ro to R1 and income rises from Yo to Y1. The increase in money stock creates an excess supply of money, which causes the interest rate to fall. As the interest rate falls, investment demand is increased, and this increase causes income to rise with an increase in consumption demand due to the change in
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