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![Page 1: Principles of Economics](https://reader035.fdocuments.net/reader035/viewer/2022062407/56812c26550346895d9093d6/html5/thumbnails/1.jpg)
Principles of Economics
Session 14
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Topics To Be Covered
Equilibrium of the Goods MarketEquilibrium of the Money MarketThe IS-LM ModelThe AS-AD Model
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The Big Picture
Liquid PreferenceKeynesian Cross
IS Curve LM Curve
AS-AD Model
Explanation of Short-Run Fluctuations
IS-LM Model
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The Keynesian Cross
Demand
45°
Output=Demand
Output
Dem
and
0
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Equilibrium of the Goods Market
Unplanned Inventory: $0 Income: $1000
Planned Saving:
$200
Planned
Inve
ntory
=
Planned
Inve
stmen
t: $2
00Planned Consum
ption: $800
Planned Expenditure = AD: $1000
Ou
tput
= A
S: $
1000
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I200
S
Demand
45°
Equilibrium of the Goods Market
Output1000
1000
1000
Dem
and
(Pla
nn
ed E
xpen
dit
ure
)
0
0
Pla
nn
ed S
avin
g an
d
Inve
stm
ent
Output
Output=Demand, so the goods market is at equilibrium.
I = S
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Contraction of the Goods Market
Unplanned Inventory: $200 Income: $1000
Planned Saving:
$400
Planned
Inve
ntory
=
Planned
Inve
stmen
t: $2
00Planned Consum
ption: $600
Planned Expenditure = AD: $800
Ou
tput
= A
S: $
1000
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I200
S
Demand
45°
Contraction of the Goods Market
Output
Dem
and
(Pla
nn
ed E
xpen
dit
ure
)
0
0
Pla
nn
ed S
avin
g an
d
Inve
stm
ent
Output1000
400
1000
800
Output >Demand, so the goods market
tends to contract.
S > I
Equilibrium output
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Expansion of the Goods Market
Unplanned Inventory: - $200 Income: $1000
Planned Saving:
$0
Planned
Inve
ntory
=
Planned
Inve
stmen
t: $2
00Planned Consum
ption:$1000
Planned Expenditure = AD: $1200
Ou
tput
= A
S: $
1000
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I200
S
Demand
45°
Expansion of the Goods Market
Output
Dem
and
(Pla
nn
ed E
xpen
dit
ure
)
0
0
Pla
nn
ed S
avin
g an
d
Inve
stm
ent
Output
1000
1200
Equilibrium output
1000
Output <Demand, the goods market
tents to expand.
S < I
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Equilibrium of the Goods Market
GDPPlanned
ConsumptionPlanned Saving
Planned Investment GDP
Total PlannedC and I
Resulting Tendency of Output
1000 600 400 200 1000 800 Contraction
1000 800 200 200 1000 1000 Equilibrium
1000 1000 0 200 1000 1200 Expansion
>=<
When the goods market is at equilibrium, planned investment equals planned saving.
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The IS Curve
The IS curve is a graph of all combinations of interest (r) and output (Y) that result in goods market equilibrium.
When the goods market is at equilibrium
Output=Planned Expenditure
Planned Investment = Planned Saving
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Deriving the IS curve
Y
E
r
Y
E1 =C +I (r1 )+G
r1
E =Y
IS Curve
E2 =C +I (r2 )+G
I
E
Y
r I
Y1
Y1
r2
Y2
Y2
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Deriving the IS Equation
I = investment r = interest rate e > 0, d > 0
dreI =
dreGCGdreC
GICY
)()(
Ydd
eGCr
1
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The Downward-Sloping IS Curve
A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending.
To restore equilibrium in the goods market, output must increase.
Output increases
Interest rate falls
Investment spending increases
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The Downward-Sloping IS Curve
dreGCY )(
Ydd
eGCr
1
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Fiscal Policy and the IS Curve
At any value r, increase in government purchase (G) results
in more expenditure and consequently more output (Y),
so the IS curve shifts to the right.
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Fiscal Policy and the IS Curve
Y
E
r
Y
E1 =C +I +G1
r1
E =Y
IS1
E2 =C +I +G2
G
Y1
Y1
IS2
Y2
Y2
YMPC
GY
1
1
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The Demand for Money(The Liquid Preference)
Transaction demand for moneyThe needs or desires of individuals or firms to make purchases on short notice without incurring excessive costs.
Speculative demand for moneyAn attitude that holding money over short periods is less risky than holding stocks or bonds.
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The Transaction Demandfor Money
The transactions demand for money is based on the desire to facilitate transactions.
It mainly depends on the income, so its function is:
) (Y L L1 1
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The Speculative Demandfor Money
The speculative demand for money is based on the desire to make wise decisions to invest in securities such as bonds.
It mainly depends on the interest, so its function is:
) (r L L2 2
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The Speculative Demandfor Money
When the interest is high, the bond price is low. Usually people will guess that the bond price is to rise, so they purchase bonds, thus having less money in hand.
Lessmoneyin hand
highinterest
rates
Purchasingbonds
Lowbondprices
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The Speculative Demandfor Money
When the interest is low, the bond price is high. Usually people will expect that the bond price is to fall, so they sell the bonds they own. Consequently they have more money in hand.
Moremoneyin hand
Lowinterest
rates
Sellingbonds
Highbondprices
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Demand for Money
hr kY r L Y L L L L ) ( ) (2 1 2 1
m
rL1=L1(Y)
L2=L2(r)
m
r
L=L1+ L2
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Equilibrium of the Money Market
L m When the money market is at equilibrium,
the demand for money (L) should be equal to the supply of money (m).
The money supply is controlled by the central bank.
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Equilibrium of the Money Market
m
rL
m1
m1
r1E
When money demand and supply equal, the money
market is at equilibrium
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The LM Curve
The LM curve is a graph of all combinations of interest (r) and output (Y) that result in money market equilibrium.
When the money market is at equilibrium, the demand for and the supply of real money balances.
hr kY L m
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Deriving the LM Curve
m1 m
rL1
r1 E1
Y
r
r1 E1
Y1 Y2
L2
r2 E2
LM Curve
The Market for Real Money
Balances
The LM Curve
r2 E2
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Deriving the LM Equation
m = supply of real money r = interest rate k > 0, h > 0
hrkYm =
rk
h
k
mY
Yh
k
h
mr
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The Upward-Sloping LM Curve
An increase in income raises money demand. Since the supply of real balances is fixed, there is now excess demand in the money market at the initial interest rate.
The interest rate must rise to restore equilibrium in the money market.
Interest raterises
Outputincreases
Demand for money increases
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The Upward-Sloping LM Curve
rk
h
k
mY
Yh
k
h
mr
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Monetary Policy andthe LM Curve
At any value r, increase in output requires more money supply to
maintain the interest rate constant, so the LM curve shifts
to the right.
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Monetary Policy and the LM Curve
m1 m
rL1
r1 E1
Y
r
r1 E1
Y1 Y2
L2 LM1
The Market for Real Money
Balances
The LM Curve
E2
LM2
E2
m2
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The IS-LM Model
The IS-LM model is a graph showing the short-run equilibrium
with the combination of r and Y that simultaneously satisfies the
equilibrium conditions in the goods and money markets.
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The IS-LM Model
Y
r
E
Equilibrium output
LM
IS
Equilibrium interest
rate
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The IS-LM Model
Y
r
E
Equilibrium output
LM
IS
Equilibrium interest
rate
A
BC
D
F
G
For A, B, and C,
I < S.
For D, F, and G,
I > S.
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The IS-LM Model
Y
r
E
Equilibrium output
LM
IS
Equilibrium interest
rate
AB
C DF
G
For A, B, and C,
L < M.
For D, F, and G,
L > M.
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The IS-LM Model
Y
r
E
Equilibrium output
LM
IS
Equilibrium interest
rate
L < MI < S
L > MI > S
L < MI > S
L > MI < S
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The Policy and the IS-LM Model
Policymakers can affect macroeconomic variables with
fiscal policy: G and/or T
monetary policy: M
The IS-LM model can be applied to analyze the effects of these policies.
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The Fiscal Policy andthe IS-LM Model
IS1 Y
r
LM
r1
Y1
IS2
Y2
r2
![Page 41: Principles of Economics](https://reader035.fdocuments.net/reader035/viewer/2022062407/56812c26550346895d9093d6/html5/thumbnails/41.jpg)
The Monetary Policy andthe IS-LM Model
ISY
r
LM1
r1
Y1
LM2
Y2
r2
![Page 42: Principles of Economics](https://reader035.fdocuments.net/reader035/viewer/2022062407/56812c26550346895d9093d6/html5/thumbnails/42.jpg)
Interaction between Monetary and Fiscal Policy
Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa.
Such interaction may alter the impact of the original policy change.
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Monetary Policy in Response to Fiscal Policy
Suppose the government increases G.Possible central bank’s responses:
hold M constant hold r constant hold Y constant
In each case, the effects of the G are different.
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Response 1: Hold M Constant
IS1
Y
r
LM1
r1
Y1
IS2
Y2
r2
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Response 2: Hold r Constant
IS1
Y
r
LM1
r1
Y1
LM2
IS2
Y2
r2
Y3
![Page 46: Principles of Economics](https://reader035.fdocuments.net/reader035/viewer/2022062407/56812c26550346895d9093d6/html5/thumbnails/46.jpg)
Response 3: Hold Y Constant
IS1
Y
r
LM1
r1
Y1
LM2
IS2
Y2
r2
r3
![Page 47: Principles of Economics](https://reader035.fdocuments.net/reader035/viewer/2022062407/56812c26550346895d9093d6/html5/thumbnails/47.jpg)
Keynesian Trap
LM
Y
r
IS2IS1
IS4
IS3
Keynesian trap or liquid preference trap, over where
fiscal policy works most efficiently
Classical situation where fiscal policy
has no positive effect.
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Deriving the AD curve
Y
r
Y
P
IS
LM(P1)
AD
P1
r1
Y1
Y1
P2
LM(P2)
r2
Y2
Y2
r
P (M/P)
I
Y
LM
![Page 49: Principles of Economics](https://reader035.fdocuments.net/reader035/viewer/2022062407/56812c26550346895d9093d6/html5/thumbnails/49.jpg)
Monetary Policy and AD Curve
Y
r
Y
P
IS
AD1
P1
LM(M1/P1)
LM(M2/P1)r1
r2
Y1
Y1
r
M LM
I
Y at each P
Y2
Y2
AD2
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Fiscal Policy the AD curve
Y
r
Y
P
IS1
AD1
P1
LM
r1
r2
Y1
Y1
G IS
Y at each P
Y2
Y2
AD2
IS2
![Page 51: Principles of Economics](https://reader035.fdocuments.net/reader035/viewer/2022062407/56812c26550346895d9093d6/html5/thumbnails/51.jpg)
The Downward-Sloping AD Curve
The aggregate demand curve slopes downward for three reasons: The wealth effect The interest-rate effect The exchange-rate effect
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The Wealth Effect
A decrease in the price level increases the purchasing power of nominal money, thus making consumers feel more wealthy and in turn spend more.
The increased consumption raises AD. Pigou Effect
LevelPrice
Wealth NominalWealth Real
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The Interest Rate Effect
A lower price level increases the supply of real money, which reduces the interest rate and in turn encourages investment.
The increased investment raises AD. Keynesian Effect
(P) LevelPrice
(M) Supply Money Nominal(m) Supply Money Real
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The Exchange-Rate Effect
When a fall in the domestic price level causes domestic interest rates to fall, the real exchange rate depreciates, which stimulates net exports.
The increased net export raises AD. Mundell-Flemming Effect
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The AS Curve
In the long run, the aggregate-supply curve is vertical.
In the short run, the aggregate-supply curve is upward sloping.
![Page 56: Principles of Economics](https://reader035.fdocuments.net/reader035/viewer/2022062407/56812c26550346895d9093d6/html5/thumbnails/56.jpg)
The Upward-Sloping AS Curve
Y
PAS
P1
Y1
P2
Y2
![Page 57: Principles of Economics](https://reader035.fdocuments.net/reader035/viewer/2022062407/56812c26550346895d9093d6/html5/thumbnails/57.jpg)
The Upward-Sloping AS Curve
The upward-sloping short-run AS curve can be accounted for with the following theories:The Misperceptions TheoryThe Sticky-Wage TheoryThe Sticky-Price Theory
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The Misperceptions Theory
Changes in the overall price level temporarily mislead suppliers about what is happening in the markets in which they sell their output: A higher price level causes misperceptions
about relative prices. These misperceptions induce suppliers to
increase the quantity of goods and services supplied.
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The Sticky-Wage Theory
Nominal wages are slow to adjust, or are “sticky” in the short run: Wages do not adjust immediately to a rise in
the price level. A higher price level makes employment
and production more profitable. This induces firms to increase the quantity of
goods and services supplied.
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The Sticky-Price Theory
Prices of some goods and services adjust sluggishly in response to changing economic conditions: An unexpected rise in the price level leaves
some firms with lower-than-desired prices. This increases sales, which induces firms to
increases the quantity of goods and services they produce.
Menu cost
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The Vertical AS Curve
In the long-run, an economy’s production of goods and services depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services.
The price level does not affect these variables in the long run, so the AS curve is vertical.
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The Vertical AS Curve
Y
P
Potential output
2. …does not affect the quantity of goods and services supplied in the long run.
P2
1. A change in the price level…
P1
AS
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The Vertical AS Curve
The long-run aggregate supply curve is vertical at the potential output.
This level of production is also referred to as natural rate of output or full-employment output.
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Shifting of the Vertical AS Curve
Any change in the economy that alters the natural rate of output shifts the long-run aggregate-supply curve.
The shifting of long-run AS curve may arise from the change of: Labor Capital Natural resources Technology knowledge
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1. In the long-run, technological progress shifts long-run AS...
LRAS2000LRAS1990
Shifting of the Vertical AS Curve
Y
P
0
P1980
Y1980
AD1980
P2000
P1990
LRAS1980
2. …and growth in the money supply shifts AD...
AD2000
AD1990
4. …and ongoing inflation.
Y1990 Y2000
3. …leading to growth in output...
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The AD-AS Model
Y
P
0
Short-run AS
AD
AEquilibrium price
Long-run AS
Potential Output
![Page 67: Principles of Economics](https://reader035.fdocuments.net/reader035/viewer/2022062407/56812c26550346895d9093d6/html5/thumbnails/67.jpg)
1. A decrease inaggregate demand…
AD2
The AD-AS Model
Output
PriceLevel
0
Short-run aggregatesupply, AS1
Long-runaggregate
supply
Aggregatedemand, AD1
AP1
Y1
BP2
Y2
2. …causes output to fall in the short run…
AS2
CP3
3. …but over time,the short-run aggregate-supply curve shifts…
4. …and output returnsto its natural rate.
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From AE-NI, IS-LM to AD-AS
The AE-NI model (Keynesian cross) assumes that the interest and price level are constant. Thus, the multiplier effect is great.
The IS-LM model assumes that the price level is constant but that the interest rate is variable. Thus, the crowding out effect is taken into consideration.
The AD-AS model assumes that the interest rate and price level are variable.
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From AE-NI, IS-LM to AD-ASThe expansionary fiscal policy will cause the
price level to rise. The rise of price level means the decrease of the real money supply, thus the interest rate is even higher. Thus the crowding-out effect is even greater when the price-level is considered in the context of AD-AS model.
Governmentpurchasesincrease
Crowding-out effectincreases
Pricelevel
increases
Real moneysupply
decreases
Interestraterises
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Y
E
r
Y
E1 =C +I(r1)+G1
E1
IS1
Y1
LM1
Y2
Y2
Y2
r
Y
AD1
P1
AD2
E4
E4 =C +I(r3)+G2
Y1
Y1
E3 =C +I(r2)+G2
E3
AD3
AS1
Y3
Y3
Y3
Y4
Y4
Y4
E2 =C +I(r1)+G2
E2
IS2
r1
r2
P2
LM2r3
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Assignment
Review Chapter 1—30.Go over handouts.Be alert to economic phenomena around
you and try to understand them with the help economic principles.
Apply what you’ve learned to your studies and life.
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Thanks