IV' ISLM MODEL

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IV. IS-LM MODEL

• The IS-LM Model
• Ch. 5

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Money market recapitulation

• Interest rate is determined on the money market.

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Money and prices

• What we have got by having money?
• Prices!
• PQ MV
• Vvelocity of money
• P P(M)

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Explanatory power of interest rate

• Consumption
• Investment

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Consumption and interest rate

• C C(Y)
• C C(Y,i)
• Interest affect consumption in two ways
  substitution and income effect

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Consumption function

• We shall work with unchanged consumption
  function
• C C(Y)
• C C0 c Y.

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Investment and interest rate

• I I0 all investment is autonomous
• I I(Y,i)
• Y future sales, expected output
• i determine cost to borrow

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Investment function

• I I(i)
• I I0 b i.

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IS-LM MODEL
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outline

• Equilibrium in the goods market IS relation
• Equilibrium in the financial markets LM relation
• Macroeconomic equilibrium IS-LM
• Dynamics and applications of IS-LM model

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IS relation

• The goods market and IS relation
• AS AD
• AS Y
• AD C I G.
• C C0 c Y
• G G0
• I I( ? )

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Investment function

• I I0 bi.

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IS relation

• What is the combination of income (Y) and
  interest rate (i) that brings the good market
  into equilibrium, AS AD?

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Derivation of IS relation

• Using algebra
• Y CIG.
• IS equation
• Y (1/(1-c)) A (b/(1-c)) i.

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Derivation II

• Using graph IS relation relation between
  interest rate and output

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Shifts in the IS curve
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LM relation

• Financial markets and the LM relation.
• What is the combination of income (Y) and
  interest rate (i) that brings money market into
  equilibrium?

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LM relation II

• MS MD
• MS M/P real money.
• MD L(iY) Y real income
• M/P L(iY)

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Deriving the LM relation

• Algebraic derivation
• MS MD
• M/P kY hi.
• LM equation
• i (k/h) Y (1/h)(M/P).

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Derivation II

• Using graph LM relation relation between
  interest and income

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Shift of the LM curve
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Equilibrium

• Putting the IS and LM relations together.

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Macro
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Equilibrium II

• Algebraic solution
• IS YC(Y)I(i)G
• Y A a i.
• LM M/P L(i,Y) kY-hi
• i B b Y.

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Fiscal policy

• Activity, and the interest rate
• Fiscal contraction
• Fiscal expansion

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Fiscal policy II

• The effect of an increase in government spending.

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Monetary policy

• Activity, and the interest rate.
• Monetary expansion
• Monetary contraction

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Monetary policy II

• The effect of a monetary expansion

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Policy mix

• Monetary-fiscal policy mix

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About the IS-LM model

• Does the IS-LM model fit the facts?
• Does the IS-LM model provide reliable
  predictions?

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Short and medium run

• In short run assumptions about prices and supply
  curve could be reasonable
• In medium run such assumption are not tenable any
  more.
• We need a new model for a medium run.