Tutorial 4 (IS-LM Model) (Answers are provided as a guide but not limited to the

following)

1. First, define the LM curve. Second, explain why it has a particular shape.

Suggested answer:

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. Rise in money demand will exert upward pressure on interest rate to
rise too. Therefore, when income increases, interest rate increases too, causing LM to be
positively upward sloping.

• 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 (at the initial interest
rate) or rather an excess supply of bonds (when people convert or sell bonds to hold cash for
transactions). Excess supply of bonds will cause bond prices will fall and the interest rate will
increase until equilibrium is restored (note: bond prices is inversely related to interest rate).

2. Explain the determinants of investment. Include in your answer an explanation of

how a change in each determinant affects investment.

Suggested answer:

Investment depends on the level of sales/output (Y) and on the interest rate (i). As output
changes, the demand for goods will change and firms will change investment so that their
capacity changes in accordance to the level of economic activity (or demand). Hence,
investment is positively related to income.
Investment also depends on the interest rate. As the interest rate rises, the cost of borrowing
rises. Firms will cut back on investment as borrowing costs rise. Investment is negatively
related to interest rate.

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.

Suggested answer:

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 LM to shift upward
left by moving along the IS curve following monetary contraction (reduction in nominal money
supply). When interest rate increase following a decrease of money supply (monetary
contraction), investment will decline, hence output level also reduced.

Y
4. A fiscal expansion (assuming 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.

Suggested answer:

The fiscal expansion will cause an increase in output. Assuming a fiscal expansion is executed
via an increase in government spending. This will cause IS curve to shift upward right and both
interest rate rises and output level rise. However, changes in Y following shifting of IS only
cause a movement 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 Central Bank sale of bonds (OMO sell) will have on:
(a) the LM curve; and

(b) the IS curve.

Suggested answer:

Sale of bonds executed via OMO selling by Central Bank will cause a reduction in H (monetary
base) given money multiplier, hence reducing money supply in an economy. This represents a
contractionary monetary policy since the sale of bonds mop up excess liquidity in the market.
This will cause an excess demand for money and the interest rate must increase to restore
money market equilibrium.

The LM curve will shift upward left from LM’ to LM 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 when LM shifted upward left, where higher interest rate from
i’ to i will cause decline in investment as seen in the movement along IS curve.