Answer to Question #173757 in Macroeconomics for innocent kampumba

Question

3. About the IS-LM model

a) Discuss the market under consideration.

b) State Walras law.

c) Explain the reason for the negative relationship between interest rates and income in the goods market.

d) Making relevant assumptions, show the graphical derivation of the IS curve.

e) Making relevant assumptions, show the graphical derivation of the LM curve .

f) Within the IS-LM framework, explain how contractionary fiscal policy works using tax as a policy tool.

g) Assuming the Zambian economy is characterised by the minimum interest rate below which it cannot change, discuss monetary policy within the situation.

Answer 1

3.

a) The IS-LM model, which stands for "investment-savings" (IS) and "liquidity preference-money supply" (LM) is a Keynesian macroeconomic model that shows how the market for economic goods (IS) interacts with the loanable funds market (LM) or money market.

b) Walras's law is an economic theory, which states that the existence of excess supply in one market must be matched by excess demand in another market so that both factors are balanced out.

c) Higher interest rates increase the cost of borrowing, reduce disposable income and therefore limit the growth in consumer spending.

d) In the derivation of the IS curve we seek to find out the equilibrium level of national income as determined by the equilibrium in goods market by a level of investment determined by a given rate of interest. Thus IS curve relates different equilibrium levels of national income with various rates of interest.

e) The LM curve can be derived from the Keynesian theory from its analysis of money market equilibrium. The greater the level of income, the greater the amount of money held for transactions motive and therefore higher the level of money demand curve.

f) The increase in taxes will shift the IS curve leftwards, as a result both equilibrium interest rate and income level will decrease.

g) If the Zambian economy is characterised by the minimum interest rate below which it cannot change, then the monetary policy within the situation can use open-market operations, changes in reserve ratio and in money supply.