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.

2444_Explain the problem with IS-LM model1.png

432_Explain the problem with IS-LM model.png

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.


Related Discussions:- Explain the problem with IS-LM model

Determine about the interest rates, Determine about the interest rates ...

Determine about the interest rates The interest rate may be fixed or floating. If it is fixed, you will pay the same percentage for the entire duration of the loan. With a floa

Consumption, Consider two consumers, A and B. A and B both want perfect con...

Consider two consumers, A and B. A and B both want perfect consumption smoothing (c = cf) and both have no current wealth. However, the two consumers have different income streams.

Real exchange rates, Real Exchange Rates (EXCH) is the next variable that w...

Real Exchange Rates (EXCH) is the next variable that will be analysed in this VAR. The reason for including exchange rates in the VAR is that they are an important channel through

Compute total demand and firms profit, Suppose three identical firms are e...

Suppose three identical firms are engaged in Cournot competition in quantities. They all have marginal costs equal to 40. Market demand is given by: P(X) = 200 - X = 200 - (x

Detetrmine gross investment and government expenditure, The following is th...

The following is the information from the national income accounts for a hypothetical country:  GNP                                                                  Rs. 5000.00

Price elasticity of demand, Suppose that quantity demand falls by 30% as a ...

Suppose that quantity demand falls by 30% as a result of a 5% increase in price. What would be the price elasticity of demand for this good?

Permanent Income, 5. In this question you should assume that the Marginal P...

5. In this question you should assume that the Marginal Propensity to Consume out of permanent income is one [i.e., no bequest motive + perfect consumption smoothing: c1, = c2 = c

Analyse the assumptions of price elasticity, In an article about the financ...

In an article about the financial problems of USAToday,News week reported that the paper was losing about $20 million a year. A Wall Street analyst said that the paper should raise

Welfare economic, Write the compensation principal of socitovsky

Write the compensation principal of socitovsky

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd