Tutorial 4 Solution (IS LM Model)

1. First, define the LM curve. Second, explain why it has its particular
shape.
The LM curve illustrates the combinations of the interest rate and level of
output that maintain financial market equilibrium. The curve is upward sloping
because as income increases, money demand will rise.
M = $Y L(i)
Divide both sides of the equation by the price level P:

This increase in money demand will cause an excess demand for money and an
excess supply of bonds. Bond prices will fall and the interest rate will increase
until equilibrium is restored.
2. Explain the determinants of investment. Include in your answer an
explanation of how a change in each determinant affects investment.
Investment depends on the level of sales/output and on the interest rate. As
output changes, the demand for goods will change and firms will change
investment so that their capacity changes with the level of economic activity
(and demand). Investment also depend on the interest rate. As the interest rate
rises, the cost of borrowing rises. Firms will cut back on investment as
borrowing costs rise.
3. When the central bank pursues contractionary monetary policy, it will
result in an increase in the interest rate, a reduction in investment, a
reduction in demand, and a lower level of equilibrium output. Explain
what happens to the position of the IS curve as the central bank pursues
contractionary monetary policy.
Changes in the interest rate do cause changes in investment, demand, and
output. However, they do not cause shifts of the IS curve. Changes in the
interest rate cause movements along the IS curve.

4. A fiscal expansion (e.g. a tax cut) will result in an increase in income, an

increase in money demand, and an increase in the equilibrium interest rate
in financial markets. Explain what happens to the position of the LM
curve as policy makers pursue expansionary fiscal policy
The fiscal expansion will cause an increase in output. However, changes in Y
only cause movements along the LM curve. The effects of changes in Y on the
interest rate are embedded in the shape of the LM curve.

5. Explain in detail what effect a Fed sale of bonds will have on: (1) the LM
curve; and (2) the IS curve.
A Fed sale of bonds will cause a reduction in H (monetary base) and a reduction
in the money supply. This will cause an excess demand for money and the
interest rate must increase to restore money market equilibrium. The LM curve
will shift up as a result of this to reflect the now higher interest rate. The IS
curve does not shift as a result of this. We would simply observe a movement
along the IS curve where higher interest rate will cause decline in investment as
seen in the movement along IS curve.