Question

The recent crisis in Greece led to an increase in its risk premium. Using the IS-LM model for a small open economy, show the impact of this increase in risk premium on output, net exports, exchange rate, and investment. Do you think the results obtained from this model represent the real-world scenario? Why or why not? Discuss.

Answer 1

Answer:

The IS-LM model constitutes one of the central nuclei of the neoclassical synthesis and shows the relationship between interest rates, the real product, the market for goods and services, and the money market.

Explanation:

It should be noted that the IS-LM model is an instrument for the static analysis of the economy but constitutes a valuable contribution to the understanding of macroeconomics and economic policy, that is, fiscal policy and monetary policy. Before the existence of this model, there were no methodological tools to adopt economic policies, and great crises such as the Great Depression of the 1930s are attributed to its absence. It should be noted that this model is used to study the short term, and when prices are relatively stable or there is low inflation. Hence, it does not establish significant differences between the nominal interest rate and the real interest rate (adjusted for inflation).

I think some of  the advantages of the IS-LM model are that it makes it easier to understand how the money market works, It simplifies the balance of the investment and savings market, taking into account the main variables. It is one of the most prestigious theoretical models.

In the same way, as every model also has disadvantages with some limitations, for example it is a simple model, it does not include many other factors that could affect the market balance. There is discussion to estimate the slopes of the IS and LM curves. Critics indicate that among the variables they should include are the wage and price curve.