IS-LM MODEL
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Transcript of IS-LM MODEL
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IS-LM MODEL
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Equilibrium in product market with I autonomous
In SKM equilibrium in product market implies Y = C+I
where, Y is national income/national product; C is consumption which is a function of Y and I is investment (exogenously given)
o Thus, solving Y= C(Y)+ Io we obtained the equilibrium Y
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Equilibrium in product market with I as a function of Y
Y = C(Y) + I(Y) Solving this we can obtain
equilibrium Y
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Equilibrium in product market with I as a function of interest rate ‘r’
Let I = I (r) where I’ (r) <0 Now AD=C+I. So given C, an
increase in I → AD↑ at each level of income → equilibrium Y
This implies that there will be different equilibrium values of Y at different rates of interest
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The IS curve
The curve that shows the different equilibrium values of Y at different rates
of interest is called IS-curve
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What is an IS-curve?
The IS-curve represents the different pairs of ‘r’ & ‘Y’ at which the product market is in equilibrium. at which
Y = C(Y) + I(r)or, S(Y) = I(r)
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Problem encountered in determining product market equilibrium with I(r)
The equilibrium value of ‘Y’ cannot be determined without knowing the equilibrium value of ‘r’
Qs: How is equilibrium ‘r’ determined?
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Determination of ‘r’
In Keynes’ liquidity preference theory of interest equilibrium ‘r’ is determined by demand for & supply of money
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Supply of & demand for money
Let nominal money supply (M0)& general price level (P) be given. So real money supply is
o The Keynesian demand for money function/liquidity preference function is
M0/P.
Md/P = L1(Y) + L2 (r) = L (Y,r)
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Explanation of terms in demand function
L1(Y)→ demand for active real balances→ L1’(Y) > 0
L2 (r)→ demand for idle (or speculative) cash balances in real terms → L2’(r) < 0 (so long r is higher than a certain minimum rate r min but lower than a certain maximum rate r max
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Explanation of terms in demand function
The minimum rate of interest r min is called the floor rate → at this rate demand for real speculative balances is perfectly interest-elastic
At r max at which demand for real speculative balances is zero
L’(r) < 0 so long as ‘r’ lies between the two extreme rates
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Money market equilibrium
The equilibrium is given by the equality of supply of real money balances to the demand for it M0/P0 = L (Y, r)
= L1(Y) + L2(r)In the equilibrium equation there are two unknowns ‘Y’ & ‘r’. So equilibrium value of ‘r’Will depend on the level of ‘Y’ given the L (Y, r)→ there are different equilibrium values of ‘r’ at different levels of income ‘Y’
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The LM curve
The curve gives the different combinations of ‘r’ & ‘Y’ that keeps the money market in equilibrium
It shows the equilibrium interest rates at different levels of income, given the nominal money supply, the price level & the L (Y, r) function
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Problem at hand
To determine the equilibrium level of income (Y) it is necessary to know equilibrium rate of interest (r)
And to know equilibrium rate of interest (r) it is necessary to the equilibrium level of income (Y)
This necessitates simultaneous determination of equilibrium values of ‘r’ & ‘Y’
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Determination of equilibrium ‘Y’ & ‘r’ simultaneously
Mathematically-assignment Graphically – to be done in class
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Slope of IS-curve
IS –curve is downward sloping, indicating that higher levels of equilibrium income are associated with lower rates of interest
Reasonr falls → I rises→ S (=I) rises
Now S rises implies Y must have risen
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Mathematical derivation of IS slope
I’ (r) = S’ (Y)dr/dy = S’ (Y)/ I’ (r)
< 0
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Slope of LM curve
assignment
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Product mrkt & Money mrkt in equilibrium
At the intersection of IS & LM curves Figure showing ESG, ESG, EDM &
ESM –to be shown in class
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Monetary & Fiscal Policies
Two main macroeconomic policies Monetary Policy-has its initial impact on
money/asset market Fiscal Policy-has its initial impact on goods
market Goods & assets market are closely
interconnected & so both these policies have effects on both output & interest rateThe IS-LM model helps to understand the working of these policies
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Working of Monetary Policy
Let initially goods & asset mkt be in equilibrium
Suppose nominal money supply↑. P being constant M/P increases→ rightward shift of LM curve
New equilibrium shifts to right at a higher income level & lower interest rate
Figure- to be done in class
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Reasons
M↑; excess Ms; people buy financial assets creating excess demand; price of financial assets↑; yields↓; economy immediately moves towards a point to right of original given by the new LM curve at original Y
Here ‘r’ is low & public hold larger quantity of real money
Here there is excess demand for goods→ inventory run down
Output expands→ movement up the LM curve Equilibrium established at higher Y & relatively
higher r
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Transmission Mechanism
Mechanism by which the changes in monetary policy affect aggregate demand
Two stages in this mechanism An increase in real money supply causes a
portfolio disequilibrium at the prevailing interest rate & level of income i.e. people hold more money than they want→ buy more financial assets→ pushes up prices→ causes interest rate↓
Changes in interest rate affects aggregate demand via investment changes
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Fiscal Policy
Example: let government spending ↑- this is expansionary fiscal policy (figure- done in class)
G ↑; AD↑ (at unchanged r); Y↑; IS curve shifts to the right
Goods market reaches equilibrium to the right of initial equilibrium at the same ‘r’ but at higher ‘Y’
Here money market is not in equilibrium Y ↑; demand for money↑; r↑;I falls; AD falls Economy reaches final equilibrium in between
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Crowding Out
In figure explaining fiscal policy as ‘G’ rises IS curve shifts to the right at which product market is in equilibrium raising ‘Y’ at original ‘r’
As ‘r’ is allowed to rise via rise in ‘Y’ the economy reaches equilibrium in between this & original
A comparison of second & final equilibrium shows the dampening effect of interest rate on aggregate demand
‘r’ rise due to ‘G’ rise cause ‘I’ to fall G rise crowds out I spending
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How to prevent crowding out?
By preventing a rise in ‘r’ when ‘G’ rises
For this Ms must increase Figure- to be done in class
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The Aggregate Demand Curve
Shows the combinations of price level & the level of output at which the goods & money market are simultaneously in equilibrium
Figure – to be done in class
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Aggregate Supply Curve
Two related concepts: Short run aggregate supply- upward
rising – to be explained in class Long run aggregate supply-vertical;
referred to as the natural rate of output