Goods and Financial Markets Together: The IS-LM Model.
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Transcript of Goods and Financial Markets Together: The IS-LM Model.
Goods andFinancial Markets Together:
The IS-LM Model
The Goods Marketand the IS Relation
Equilibrium in the goods market exists when production, Y, is equal to the demand for goods, Z.
In the simple model (in chapter 3), the interest rate did not affect the demand for goods. The equilibrium condition was given by:
Y C Y T I G ( )
Investment, Sales (Y), and the Interest Rate (i)
Now, we no longer assume I (investment) is constantWe capture the effects of two factors affecting investment: The level of sales/income (+) The interest rate (-)
I I Y i ( , )
The Determination of Output
Y C Y T I Y i G ( ) ( , )
Taking into account the investment relation above, the equilibrium condition in the goods market becomes:
The Determination of Output
The demand for goods is an increasing function of output. Equilibrium requires that the demand for goods be equal to output.
Equilibrium in the Goods Equilibrium in the Goods MarketMarket
Deriving the IS Curve
An increase in the interest rate decreases the demand for goods at any level of output.
The Effects of an The Effects of an Increase inIncrease inthe Interest Rate on the Interest Rate on OutputOutput
The IS Curve
An increase in taxes...
Shifts of the IS Shifts of the IS CurveCurve
Financial Marketsand the LM Relation
The interest rate is determined by the equality of the supply of and the demand for money: M Y L i $ ( )
MM = nominal money stock = nominal money stock$YL$YL((ii) = demand for money) = demand for money$Y$Y = nominal income = nominal incomeii = nominal interest rate = nominal interest rate
Real Money, Real Income,and the Interest Rate
The LM relation: In equilibrium, the real money supply is equal to the real money demand, which depends on real income, Y, and the interest rate, i:
M
PY L i ( )
Recall: before, we had the same equation but in Recall: before, we had the same equation but in nominal instead of real terms (nominal income and nominal instead of real terms (nominal income and nominal money supply). Dividing both sides by P nominal money supply). Dividing both sides by P (the price level) gives us the equation above.(the price level) gives us the equation above.
Deriving the LM Curve
The Effects of an The Effects of an Increase in Income on Increase in Income on the Interest Ratethe Interest Rate
Shifts of the LM Curve
An increase in money...
Shifts of the LM Shifts of the LM CurveCurve
The IS and the LM Relations Together
Equilibrium in the goods market (IS).
Equilibrium in financial markets (LM).
When the IS curve intersects the LM curve, both goods and financial markets are in equilibrium.
IS re la tio n : Y C Y T I Y i G( ) ( , )
L M rela tio n: M
PY L i( )
The IS-LM ModelThe IS-LM Model
Fiscal Policy, the Interest Rate and the IS Curve
Fiscal contraction: a fiscal policy that reduces the budget deficit. Reducing G or increasing T
Fiscal expansion: increasing the budget deficit. Increasing G or decreasing T
Taxes (T) and government expenditures (G) affect the IS curve, not the LM curve.
Fiscal Policy, the Interest Rate and the IS Curve
The Effects of an The Effects of an Increase in TaxesIncrease in Taxes
Monetary Policy, the Interest Rate, and the LM Curve
Monetary contraction (tightening) refers to a decrease in the money supply.
An increase in the money supply is called monetary expansion.
Monetary policy affects only the LM curve, not the IS curve.
Monetary Policy, the Interest Rate, and the LM Curve
The Effects of a The Effects of a Monetary ExpansionMonetary Expansion
Recent U.S. Monetary Policy
Using a Policy Mix
The Effects of Fiscal and Monetary Policy.
Shift of ISShift of
LMMovement of
OutputMovement in Interest Rate
Increase in taxes left none down down
Decrease in taxes right none up up
Increase in spending right none up up
Decrease in spending left none down down
Increase in money none down up down
Decrease in money none up down up
German Unification and the German Monetary-Fiscal Policy Mix
U.S. Money Supply during the Great Depression (1928-1936)
U.S. Fiscal Policy during the Great Depression (1930-1947)
The U.S. Recession of 2001
Mr. Greenspan: