## Explain the problem with IS-LM model, Macroeconomics

Assignment Help:

Q. Explain the problem with IS-LM model?

The starting point of AS-AD model is an assumption in IS-LM model (and in the cross model) that limits its usefulness. This is an assumption that if firms where to choose profit maximizing quantity of L (LOPT), they would produce more than aggregate demand. In IS-LM, YOPT> YD should hold.

To realize why it is a problem in IS-LM model, we gradually increase aggregate demand by increasing G. We can explain the process using figure below.  Figure: Illustrating the problem in the IS-LM model

1. Let's begin with a given real wage W/P, an IS curve (IS0) and an LM curve. In equilibrium, we would have Y = Y0 and L = L0.

2. Now increase G so that IS curve shifts outwards from IS0 to IS1. In the first step, we increase G just enough so that Y = YOPT in equilibrium It implies exactly to the level that firms want to produce at the given real wage.

3. Firms would now want to hire LOPTthat is precisely the profit-maximizing quantity of L. It is no longer essential for firms to hire less than profit maximizing quantity as there is no longer a shortage in aggregate demand. Thus far, no problems in IS-LM model.

4. Now imagine that we increase G even more so that IS curve shifts to IS2 such that Y = Y2> YOPT. Now IS-LM model is in trouble.

5. According to production function, to produce Y = Y2 we need L = L2. However firms will only hire LOPT if real wage is constant (that is presumed in IS-LM model). LOPT is the profit maximizing quantity - to produce more would decrease profits.

6. As firms won't hire more than LOPT if real wages are constant, GDP can't be larger than of YOPT in the IS-LM model. This model simply can't give an answer to what will happen when we increase G in step 4 as we would be violating one of the main assumptions of IS-LM model.

This problem isn't limited to changes in G and shifts in IS-curve. The same problem appears when we change MS and shift LM-curve. If we shift LM-curve to the right by an amount such that Y > YOPT, the IS-LM model can't be used.

IS-LM model isn't 'wrong', but it's applicable only as long as Y > YOPT. Normally the IS-LM model will perform reasonable as long as price level is stable (low inflation) and it will do better in a recession than in a boom.

#### Two replacement compressor, You need to choose between two replacement comp...

You need to choose between two replacement compressor options. One costs \$6400 and is 70% efficient. The other costs \$9800 and is 85% efficient. Both have an average life of 8 year

#### Describe classical model of macroeconomics, Q. Describe classical model of ...

Q. Describe classical model of macroeconomics? Though we use the term ‘the classical model' as if there were just one classical model, this isn't quite true. For all the models

#### Determining the lm curve, This problem revolves around determining the LM c...

This problem revolves around determining the LM curve, as we did earlier in the term such that money demand (M D ) equals money supply (M S ), however in this instance under differ

#### During the 1990s, During the 1990s, technological advance reduced the cost ...

During the 1990s, technological advance reduced the cost of computer chips. Explain, with the use supply and demand diagrams, how the following markets are affected in terms of pri

#### Theand the protection of property rights, Why is private property, and thea...

Why is private property, and theand the protection of property rights , so critical to the success of the market system ? How do property rights encourage cooperation?

#### Determine the value of the goverment expenditure multiplier, Assume that th...

Assume that the economy is characterized by the following structural equations: C = 160 + 0.6 (4 - T) I = 150; G = 150; T = 100. a) Determine the equilibrium output level

#### Fiscal policy have occurred, What were the key provisions of the economic s...

What were the key provisions of the economic stimulus bill passed by congress in February 2008? What further changes in fiscal policy have occurred since this time?

#### Price of steel jumped, Your firm usually uses about 200-300 tons of steel p...

Your firm usually uses about 200-300 tons of steel per year. Last year, you purchased 100 tons of steel than needed (at a price of \$200 per ton) In the meantime, the price of steel

#### Explain united states do better than other countries, What does the United ...

What does the United States do better than other countries?  