2 marks, −0.667MacroeconomicsIS-LM modelExtensions: expected inflation, endogenous money and rate targetingHardabout 3 min

GATE 2023 Question 47: IS-LM model

Consider a closed-economy IS-LM model. The IS and LM equations are

$Y = C(Y) + I(z) + \bar G$ $\frac{\bar M}{\bar P} = kY - li$

where $Y$ is the output, $C$ is the consumption ( $C'>0$ ), $I$ is the investment ( $I'<0$ ), $z \equiv i-\pi^e$ , $i$ is the nominal interest rate, $\pi^e$ is the expected inflation, $\bar G$ is the government purchases, $\dfrac{\bar M}{\bar P}$ is the fixed real money balances, and $k$ and $l$ are positive constants.

Suppose everyone in the economy suddenly expects the inflation to rise in the future. Assuming that the LM curve remains unchanged, what will happen in the short-run?

Tap an option to check your answer.

Answer and worked solution

Answer: (A)

Investment depends on the real interest rate $z = i - \pi^e$ , while the LM curve is expressed in terms of the nominal interest rate $i$ (money demand $kY-li$ uses $i$ , not $z$ ).

Since the LM curve is unchanged (fixed in $(Y,i)$ space), for any given nominal rate $i$ that clears the money market, a rise in expected inflation $\pi^e$ lowers the real rate $z=i-\pi^e$ at that same $i$ . A lower real rate makes investment more attractive (recall $I'(z)<0$ , so lower $z$ means higher $I$ ), which shifts the IS curve to the right (more investment demand at any given $i$ ).

With IS shifting right and LM unchanged, the new intersection has a higher equilibrium $Y$ (and typically also a higher nominal $i$ , though $Y$ is what's asked here).

Therefore, in the short run, equilibrium Y increases — answer (A). This is essentially the Mundell-Tobin effect operating through the goods market: higher expected inflation stimulates real investment demand by lowering the real cost of borrowing at a given nominal rate.

The trap: (C) Equilibrium Y remains unchanged.

Students who don't carefully track the distinction between the real rate (which drives investment, via $z$ ) and the nominal rate (which the LM curve is built on, via $i$ ) may assume 'the LM curve is unchanged, so nothing in the model has really changed' and default to 'equilibrium Y remains unchanged' — missing that the IS curve itself shifts even though LM does not, because IS depends on the real rate while LM is anchored to the nominal rate.

Plain-text version

Consider a closed-economy IS-LM model. The IS and LM equations are Y = C(Y) + I(z) + Ḡ M̄/P̄ = kY - li where Y is the output, C is the consumption (C′>0), I is the investment (I′<0), z ≡ i-π^e, i is the nominal interest rate, π^e is the expected inflation, Ḡ is the government purchases, M̄/P̄ is the fixed real money balances, and k and l are positive constants. Suppose everyone in the economy suddenly expects the inflation to rise in the future. Assuming that the LM curve remains unchanged, what will happen in the short-run? (A) Equilibrium Y increases. (B) Aggregate demand remains unchanged. (C) Equilibrium Y remains unchanged. (D) Aggregate demand shifts down.

Also written as: Consider a closed-economy IS-LM model. The IS and LM equations are Y = C(Y) + I(z) + G_bar M_bar/P_bar = kY - li where Y is the output, C is the consumption (C'>0), I is the investment (I'<0), z == i-pi^e, i is the nominal interest rate, pi^e is the expected inflation, G_bar is the government purchases, M_bar/P_bar is the fixed real money balances, and k and l are positive constants. Suppose everyone in the economy suddenly expects the inflation to rise in the future. Assuming that the LM curve remains unchanged, what will happen in the short-run?

IS-LM model has come up 137 times in 7 exams since 2004.

What this question tests

This question is on Extensions: expected inflation, endogenous money and rate targeting, part of IS-LM model in Macroeconomics.

Variations on the basic model: inflation expectations, money supply that responds, and central banks that target the rate.

TestStop has 14 past-paper questions on this subtopic.

Take this paper as a timed mock More on Extensions: expected inflation, endogenous money and rate targeting

Question from the GATE 2023 paper. Solutions are TestStop's own. Not affiliated with or endorsed by any examination authority.