Goods and of Financial Market : The IS-LM Model
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Goods and of Financial Market : The IS-LM Model
The Goods Market and The IS Relation
Y = C (Y-T) + I + G
Investment, Sales, and The Interest Rate
I = I (Y, i)
(+, -)
Where : Y = Production
i = Interest rate
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The IS Curve
Y = C (Y-T) + I (Y, i) + G
The supply of goods (the left side) must be equal to the demand for goods (the right side)
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The Effects of an Increase in The Interest rate on Output
Demand, zFor interest rate, i
A’
A
Y’ Y Output, Y
ZZ
ZZ’
For interest rate I’>i
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The Derivation of the IS Curve
A’
A
Y’ Y Output, Y
ZZ
ZZ’
Output, Y
Interest rate, i
i’
i
Y’ Y
IS curve
A’
A
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The Shifts in the IS Curve
Output, Y
Interest rate, i
IS ( For taxes T)
IS ( for T’>T)
i
Y’ Y
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Financial Markets and The LM Relation
MS = M d
M = $ YL (i)
Variable M on The left side is the nominal money stock
M/P = Y L (i) ………….. LM Relation
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The effects of an increase in Income on the interest rate
M d’ (for Y’> Y)
M d (for Income Y)
A
A’i’
i
Interest rate, i
M/P Real Money, M/P)
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The Derivation of The LM Curve
Income, Y
M d’ (for Y’> Y)
M d (for Income Y)
A’
A A
A’
M/P (Real Money, M/P)
i i
I’ I’
Y Y’
Interest rate, i Interest rate, i
LM
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Shifts in The LM Curve
Income, Y
Interest rate, i
i’
i
Y
LM (for M/P)
LM ‘ (for M’/P > M/P)
An Increase in Money
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The IS-LM Model : Exercises
IS Relation Y = C(Y-T)+I(Y, i) + G
LM Relation M/P = Y L( i )
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Equilibrium in Goods Market (IS)
Interest rate, i Equilibrium in Financial Market (LM)
Income, YY
i
The IS-LM Model
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Fiscal Policy, Activity, and The Interest Rates
Decrease in G-T
Fiscal contraction/ Fiscal Consolidation
Increase in G-T Fiscal Expansion
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In answering this or any question about the effects of Changes in policy, always follow these three steps :
1.Ask how this change affects good and financial market equilibrium relations , how its shifts the IS or/and the LM Curve
2.Characterize the effects of these shifts on the equilibrium
3.Describe the effects in the words
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How The Increase in Taxes
The Increase in taxes affects equilibrium in the goods market (IS)
The increase in taxes affects decreases consumption ( because people have less disposable income ) and through the multiplier, decreases output
What Happens to the LM Curve ? nothing
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The effects of an Increase in Taxes
IS (for T)
IS’ (for T’> T)
Output, Y
Interest rate, i
i’
i
LM
Y’ Y
An Increase in taxes shifts the IS curve to the left, and leads to a decrease in equilibrium output and the equilibrium interest rate
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Monetary Policy, Activity, and The Interest Rates
Increase in Money (M)
Monetaryexpansion
Decrease in Money (M)
Monetary Contraction/Monetary Tightening
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How The Central Bank Increases Nominal Money, through open market operation (Price level is fixed)
The Increase in Nominal money affects equilibrium in the Financial market (LM)
An increase in money shifts the LM down
What Happens to the IS Curve ? Nothing
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The effects of a monetary Expansion
IS
LM (for M/P)
LM’ (for M’/P) > M/P)
Interest rate, i
Output, YY Y’
i
I’
A monetary expansion leads to higher output and a lower interest rate
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Shifts in IS
Shifts in LM
Movement in Output
Movement 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
The Effects of Fiscal and Monetary Policy
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Using a Policy Mix
o Some times monetary and fiscal policies is used to offset the adverse on the demand for goods of fiscal contraction
o Some times the monetary-fiscal mix emerges from tensions or even disagreements between the government (which is in charge of fiscal policy) and the central bank (which is in charge of monetary policy)
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Table : Selected Macro Variables for USA, 1991-1998
1991 1992 1993 1994 1995 1996 1997 1998
Budget Surplus (% of GDP)
(minus sign : deficit) -3.3 -4.5 -3.85 -2.7 -2.4 -1.04 -0.3 0.8
GDP Growth (%) -0.9 2.7 2.3 3.4 2 2.7 3.9 3.7
Interest Rate (%) 7.3 5.5 3.7 3.3 5 5.6 5.2 4.8
Source : Bureau of economic Analysis
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Deficit Reduction and Monetary Expansion
Output, Y
Interest rate, i
IS’
IS
LM
LM’
A
A’
Bi
I’
Y
The Right Combination of deficit reduction and monetary expansion can achieve a reduction in the deficit without adverse effects on output
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Adding Dynamics
Source of dynamics in goods market :
a)Production adjusts slowly to demand
b)Demand (consumption and investment) adjusts slowly to income (production)
Slow adjustment of Y in goods market
Fast adjustment of i in financial market
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Interest rate, i
Output, Y
AB
YAYB
iA
IS’
IS
Output decreases slowly
Output Increases slowly
YA
A
B
LM’
LM
iA
iB
Output, Y
Interest rate, i
Goods Market Financial Market
Interest rateAdjust
Instantaneously
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Output, Y
Interest rate, i
IS
LM’
LM
A
A’
A’’
i’
i’’
i
YY’
The Dynamic effects of a Monetary contraction
A monetary contraction leads To an increase in the interestRate. The Increase in the Interest rate leads, over timeTo decline in output
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Monetary and Fiscal Policy : an Example
Consider the following IS-LM Model :
C = 200 + 0.25 YD
I = 150 + 0.25 Y – 1000 I
G = 250
T = 200
(M/P) d = 2Y- 8000 i
M/P = 1,600
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1. Derive the equation for the IS curve
2. Derive the equation for LM curve
3. Solve for equilibrium real output
4. Solve equilibrium interest rate
5. Solve for equilibrium values of C and I
6. Now Suppose that the money supply increases to M/P = 1840. Solve Y, i, C and explain in words the effects of expansionary monetary policy
7. Set M/P equal its initial value of 1600, Now suppose that government spending increase to G = 400. Summarize the effects of expansionary fiscal policy on Y, i and C. and why if government spending decrease to G = 100