Macroeconomics Models


a. What does the IS curve represent? How can it be derived?

The IS curve is a downward sloping curve which joins together combinations of the rates of interest and national income at which the real sector is at equilibrium, the IS curve is derived as follows

The IS is derived as shown above, first in diagram A shows the relationship between interest rates (IR)and investment (I), as interest rates increase then the less is the rate of investment, therefore this interest rates are represented in diagram B which gives us the LM curve by drawing horizontal lines. In diagram C we draw a 45 degree line from the origin which helps us to derive the level of investment in diagram D, Z2 represents the aggregate demand curve while Z1 represents the aggregate demand curve minus investment, and this helps us derive the national income or output level (Y).

B. What causes the IS curve to shift to the right (left)?


Macroeconomics Models

Shifts in the IS curve:

Increased government expenditure:

An increase in government expenditure will cause the IS curve to shift to the right, a decline in government expenditure will therefore shift the IS curve to the left.

C. How is the LM curve derived from the money market equilibrium diagram?

The LM curve is derived from the assumption that money supply is not a function of interest rates and therefore given certain levels of money supply we can determine when the monetary at which levels the monetary sector is at equilibrium; the LM curve is derived as follows:

The above diagram shows the derivation of the LM curve, MS represents money supply, When there is an increase in national income from Y1 to Y2 then this will shift the money demand schedule to the right from MD1 to MD2 and for the purpose of attaining equilibrium in the money market interest rates will shift from IR1 to IR2 and this relationship helps us to derive the LM curve above.


Macroeconomics Models

D. What causes the LM curve to shift to the right (left)?

An increase in money supply will shift the LM curve to the right and a decrease in money supply will shift the LM curve to the left.

E. What are the endogenous variables in the IS-LM model?

In the IS LM curve the interest rates and the national income are the endogenous variable.

2. What is meant by using a policy mix? Give examples and explain their effects according to the IS-LM model.

A policy mix is the use of both fiscal and monetary policies, fiscal policies include the use of government expenditure while the monetary polices include money supply. An example is


Macroeconomics Models

where the government reduces expenditure, this will shift the IS curve to the left and because and the monetary policy measure here would be to decrease interest rates from IR1 to IR2 in order to push back the economy to the natural rate of output Yn.

From the above diagram when the government decrease its spending this shifts the IS curve to the left from IS1 to IS2, this will lead the monetary policy makers to decrease the interest rates for this reason the new equilibrium will be at Yn and IR2.

3. How do labour markets affect workers’ bargaining power?

Economists view the labour market as any other market whereby labour has its own demand and supply, when the supply of labour is high then wage rates are low and on the other hand when the demand for labour is high then the wage rates increase. Therefore the demand and the supply will determine the equilibrium wage rates in an economy and also determine the workers bargaining power.

4. What is meant by the efficiency wage and what does it imply about the clearing of the labour market?


Macroeconomics Models

Efficiency wage is a concept that states that wage rates are not only determined by the supply and demand of labour and for this reason there is need to pay a higher wage rate to employees to increase efficiency and productivity of labour. This concept therefore states that wage rates should be set higher than the market clearing rate in order to achieve efficiency which is achieved through the higher pay than the market clearing.

5. How does Blanchard define and motivate the concept of the natural rate of unemployment?

The natural rate of unemployment is that unemployment level that exists in an economy in the absence of temporary frictions. These frictions include the incomplete adjustments in the good and labour market.

Blanchard on the good market he assumes in his model that in the short run the production will automatically adjust and therefore in the long run the economy will not have incomplete adjustments and for this reason the economy will be experiencing natural unemployment. Therefore Blanchard motivates the concept of natural unemployment by assuming that in the long run the only rate of unemployment in the economy is the natural rate of unemployment.


Macroeconomics Models

6. Analyse the effect of expansionary fiscal policy in the short run, using AS-AD analysis.

An expansionary fiscal policy means that the government increases aggregate demand, in the short run the aggregate demand curve will shift upward as follows:

The above diagram demonstrates the effect of an expansionary fiscal policy on the AS AD model, when the government increases expenditure the aggregate demand shifts to the right from AD1 to AD2, this results into an increase in output from Y1 to Y2 and also an increase in prices from P1 to P2, for this reason in the short run the expansionary fiscal policy will be inflationary due to rise in prices and also increase the level of output of an economy.


Macroeconomics Models

7. Extend your analysis in Q3 to the medium run. What does it mean to say that money is neutral?

The wage rates are determined by the supply and demand of labour, for this reason therefore an increase in money supply by monetary policy makers will affect prices, exchange rates and wages. However this money supply increase will not affect the real economy example employment levels, the GDP and consumption. For this reason therefore money is termed as neutral for failing to affect the real economy.

8. What is meant by the expectations-augmented Phillips Curve and what are its main implications for policy makers?

The Philips curve derives the relationship that exists between unemployment and inflation, according to this curve as the rate of inflation rises then the rate of unemployment declines. The augmented Phillips curve on the other hand takes into consideration this relationship but also considers the effect of expectations on inflation and unemployment in an economy.

the expectations augmented Phillips Curve is significant to policy makers in that if there is an increase in expected inflation then there will be an increase in inflation, also given expected inflation an increase in the factors that affect wage rates will lead to increased inflation in an economy, also given expected inflation and there is an increase in unemployment rate then this will lead to decrease in inflation.

9. What is meant by the NAIRU and how can it be derived?


Macroeconomics Models

NAIRU stands for non accelerating inflation rate of unemployment, it is an optimal rate of unemployment and inflation under which if the economy’s unemployment rate falls below this set rate the economy experiences inflationary pressure. It is derived from observing the correlation of changes in the consumer’s price index and the unemployment rates in an economy,

10. Suppose a high inflation country wishes to lower its rate of inflation. What will be the impact of contractionary monetary policy according to the expectations-augmented Phillips curve framework? Why is government credibility important?

There are three types of expectations and they include fixed expectations, adaptive expectations and rational expectation, if policy makers want to lower the rate of inflation through a contractionary monetary policy then we expect the rate of inflation to decline and at the same time unemployment to increase

If we start the inflation rate at point ∏1 and the contractionary monetary policy is expected to reduce inflation to ∏2 then unemployment will increase from U1 to U2, however due to expectations the curve will shift upwards and our expected cost of reducing inflation will be higher and the rate of unemployment is expected to be at U3.

This shows the role of expectations in determining the inflation level and also unemployment in case of policy measures, the governments credibility is important the government will always


Macroeconomics Models

want to keep inflation down and at the same time keep unemployment low, for this reason if the government reduces inflation and as a result there is high unemployment then the governments credibility is questioned, if the unemployment level is reduced and there is high inflation the same case happens and therefore the government must undertake policy measures taking into considerations the costs of reduction in unemployment and inflation.


Gartner M.(2003) Macroeconomics, Prentice-Hall publishers, London

Blanchard O. (2003) Macroeconomics, 3rd edition, Prentice Hall publishers, London

Laidler D. (1981) Monetarism: An Interpretation and an Assessment, Journal of economics, March, page 1 to 28

Miles D. and Scott A. (2005) Macroeconomics: The Wealth of Nations, 2nd edition, John Wiley

publishers,                                                                                                                                                                              London

Maddock R. and Carter M. (1982) Guide to Rational Expectations, Journal of Economic, March page 39 to 51

Mankiw N. (2007) Macroeconomics, 6th edition, John Wiley publishers, London

Wyplosz C and Burda M (2005) Macroeconomics, 4th edition, Oxford University Press, Oxford


Macroeconomics Models