Putting the Markets Together

1
Putting the Markets Together

• The IS-LM Model

2
Until now, schematically
The Goods Market
The Money Market
C
Income
Money Demand
Income
Interest Rate
Money Supply

• I

G
3
From now on
The Goods Market
The Money Market
C
Money Demand
Income
Interest Rate
Money Supply

• I

G
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The IS-LM ModelAssumptions

• Analyses the short run, so
• Prices are assumed to be fixed
• Output is determined by demand
• Our own assumption closed economy (just to make
  it simpler!)

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The IS CurveEquilibrium in the Goods Market

• Equilibrium in the goods market exists when
  production, Y, is equal to the demand for goods,
  Z. This condition is called the IS relation
• In the simple model developed in chapter 3, the
  interest rate did not affect the demand for
  goods. The equilibrium condition was given by
  YC(Y-T)IG
• Lets redefine the determinants of Investment
• Interest rates and the level of sales influences
  the level of Investment, so II(i, Y)
• Redefine the equilibrium expression (YZ, also
  called IS curve)
• Y ? ?(Y-T) I(Y,i) G

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Determining Output

• For a given value of the interest rate i, demand
  is an increasing function of output, for two
  reasons
• An increase in output leads to an increase in
  income and also to an increase in disposable
  income (and then in consumption).
• An increase in output also leads to an increase
  in investment.

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The Determination of Output
Figure 5 - 1
Equilibrium in the Goods Market The demand for
goods is an increasing function of output.
Equilibrium requires that the demand for goods be
equal to output.
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The Determination of Output
Figure 5 - 1

• Note two characteristics of ZZ
• Because its not assumed that the consumption and
  investment relations in Equation (5.2) are
  linear, ZZ is, in general, a curve rather than a
  line.
• ZZ is drawn flatter than a 45-degree line because
  its assumed that an increase in output leads to
  a less than one-for-one increase in demand.

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Deriving the IS curve
Figure 5 - 2
The Effects of an Increase inthe Interest Rate
on Output

• An increase in the interest rate decreases the
  demand for goods at any level of output.

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Deriving the IS curve
Figure 5 - 3
The Derivation of the IS Curve

• Equilibrium in the goods market implies that an
  increase in the interest rate leads to a decrease
  in output. The IS curve is downward sloping.

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Deriving the IS curve

• Using Figure 5-3, we can find the relation
  between equilibrium output and the interest rate.
• Panel 5-3(a) reproduces Figure 5-2. The interest
  rate i implies a level of output equal to Y.
• Panel 5-3(b) plots equilibrium output Y on the
  horizontal axis against the interest rate on the
  vertical axis.
• This relation between the interest rate and
  output is represented by the downward sloping
  curve, or IS curve.

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The IS curve

• The slope of the IS reflects the sensitivity of
  the aggregate demand (investment) to the interest
  rate
• If aggregate demand is very sensitive to i
  (through investment), the IS curve is flat (a
  small change in the interest rate produces a
  large change in income)
• If aggregate demand is insensitive to i, then the
  IS curve will be steep.
• Changes in the interest rate moves the goods
  markets equilibrium along the IS schedule

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Shifting the IS curve
Figure 5 - 4

• Any change in exogenous components affecting
  aggregate demand (for a given level of the
  interest rate) will cause a shift IS curve
• Lets examine a shift in the IS schedule because
  of higher taxes

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Shifts in the IS curve

• What may cause a shift to the left of the IS
  curve?
• an increase in taxes (that decrease disposable
  income and therefore consumption)
• a decrease in public spending,
• a decrease in the autonomous component of
  investment (i.e., animal spirits)
• decrease in the autonomous component of
  consumption (i.e., a. decrease in consumers
  confidence)
• Lets summarize
• Equilibrium in the goods market implies that an
  increase in the interest rate leads to a decrease
  in output.
• Changes in factors that decrease the demand for
  goods, given the interest rate shift the IS curve
  to the left.

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The LM CurveEquilibrium in the Money Market

• The interest rate is determined by the demand and
  supply for money so that MsMd
• The demand for real money (real money demand
  equals real money supply), is given by
• M/P L(Y/P, i)
• We assume that Ms vertical, since it is
  exogenously determined by the Central Bank
• The Central Bank can influence the size of the M0
• If prices are fixed, then the Central Bank
  determines both the nominal and real money supply

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Derivation of the LM Curve
Figure 5 - 5
The Effects of an Increase in Income on the
Interest Rate
An increase in income leads, at a given interest
rate, to an increase in the demand for money.
Given the money supply, this leads to an increase
in the equilibrium interest rate.
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Derivation of the LM Curve
Figure 5 - 6
The Derivation of the LM Curve
Equilibrium in financial markets implies that an
increase in income leads to an increase in the
interest rate. The LM curve is upward-sloping.
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Derivation of the LM Curve

• From Figure 5-6 we learn
• Panel 5-6(a) reproduces Figure 5-5
• Panel 5-6(b) plots the equilibrium interest rate
  i on the vertical axis against income on the
  horizontal axis
• This relation between output and the interest
  rate is represented by the upward-sloping curve
  in Panel 5-6(b). This curve is called the LM
  curve.

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The LM Curve

• LM curve is upward sloping
• the higher the income, the higher the demand for
  (real) money
• To take the Money Market to equilibrium, if Ms is
  not changing, then the interest rate must
  increase.
• The LM curve will be steeper the more sensitive
  Md to income relative to the interest rate
• A flat LM curve represents a greater
  responsiveness of Md to interest rates than Y

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Shifting the LM Curve
Figure 5 - 7

• Lets consider the impact of a decision of
  increasing the money supply by the Central Bank
• For a given value of income (Y), the LM will
  shift downwards, a lower interest rate is needed
  to achieve equilibrium in the money market

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The LM Curve

• Lets summarize
• Equilibrium in financial markets implies that,
  for a given real money supply, an increase in the
  level of income increases the demand for money
  this in turn leads to an increase in the interest
  rate.
• An increase in the money supply shifts the LM
  curve down a decrease in the money supply shifts
  the LM curve up.

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The IS-LM
Figure 5 - 8
The IS-LM Model
Equilibrium in the goods market implies that an
increase in the interest rate leads to a decrease
in output. Equilibrium in financial markets
implies that an increase in income leads to an
increase in the interest rate. When the IS curve
intersects the LM curve, both goods and financial
markets are in equilibrium.
(IS) Y ? ?(Y-T) I(Y,i) (LM) M/P
f(Y/P, i)
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Next Lecture

• Now, the question is
• How do different policies affect the interest
  rate and output? How do they affect the IS and LM
  curves?