Income Determination Model Including Money and

Interest

2

Session Outline

• The Goods Market and the IS Curve

• Deriving the IS Curve

• The Money Market and the LM Curve

• Deriving the LM Curve

3

The Goods Market and IS Curve

‘IS CURVE’

“ IS curve shows different combinations of interest rates and income levels at which saving (S) is equal to investment (I)”

The Goods Market and the IS Curve

"Good market is in equilibrium when saving

equals investment."

The goods market equilibrium curve, the IS

curve shows different combinations of

interest rates and income levels at which

saving (S) is equal to investment (I). 4

Investment Function• Generally, businesses borrow to purchase

investment goods. • Higher the interest rates , lower the profitability of

the investment.• Hence, firms want to borrow and invest more

when interest rates are lower; this implies an inverse relationship between rate of interest and investment.

• Here the investment is 'planned' investment spending because only planned investment depends on the interest rate.

5

6

Investment Function• Investment Function = 0; iII

Planned investment spending

Interest rate

Where, Ї is the autonomous investment (that is, independent of both income and interest rate), ‘i' is the rate of interest and coefficient ‘ θ’ measures the responsiveness of investment to changes in interest rate

• The slope of the investment schedule shows the sensitiveness (responsiveness) of planned investment spending with respect of interest rate.

• If investment is highly responsive to interest rate, a small change in interest rate leads to a greater change in investment.

7

• A flatter investment schedule shows higher responsiveness.

• If the investment responds very little to the interest rates, then the schedule would be nearly vertical.

• As the investment curve shows the relationship between interest rate and planned investment spending, a change in the investment due to change in the factors other than interest rate would lead to a shift in the investment schedule. Thus, if autonomous investment changes the schedule shifts right or left.

 

8

• Both saving and investment are affected by interest rate

fluctuations.

• While saving is directly related to interest rate, investments

are inversely related to rate of interest.

• In other words, people save more/less when interest rates

are high/low.

• Conversely, they invest less/more when interest rates are

high/less.

9

10

Deriving the IS Curve

450

A – i1

A – i2

(AD1)

i1

i2

E2

E1

E1

E2

Y1 Y2

Income, output (a)

Y1 Y2

Income, output (b)

Interest rate

Aggregate demand

IS

(AD2)

2)1( iYtb A

1)1( iYtb A

Derivation of IS curve

At a given interest rate, equilibrium in panel (a) determines the income level. A drop in the interest rate increases aggregate demand. The IS curve shown in panel (b) depicts the resulting inverse relationship between interest rates and income.

11

12

Characteristics of Points that do not lie on the IS curve

i1

Interest Rate

Y2Y1

E3 E2

E4

E1

ESG

EDG

Income and Output (Y)

13

The Money Market and the LM Curve

‘LM’ CURVE

"LM curve shows different combinations of interest rates and income (or output) at

which demand for money (L) equals supply of money (M)"

14

Demand for Money

L1 =kY1 - hi

i1

Interest Rate

KΔY

L2 =kY2 - hi

Demand for money (L)Figure 1.4

15

Money Market Equilibrium and the LM Curve

i2

i1

LM

L

i1

i2

L2

E1

E2E2

E1

Y2Y1

L2

L1

Y

(a) (b)

16

Characteristics of Points that do not lie on the LM curve

ESM

i1

Interest Rate

Y2Y1

E1 E4

E2

E3

EDM

Income and Output (Y)

LM

17

Shift in the LM Curve

M1/P

LM1

L1

i2

i1

LM

L

i1

i2

M/P

E2

E1

E2

E1

Y2Y1 Y

(a) (b)

18

Equilibrium in the Goods and Money Markets (Simultaneous Equilibrium)

i0

Interest Rate

Y0

E

Income and Output (Y)Figure 1.8

LM

IS

19

Characteristics of Points that do not lie on the IS and LM Curves

III

II

ESM

i0

ESGESM

Interest Rate

Y0

E

EDM

Income and Output (Y)Figure 1.9

LM

EDM

EDG

ESGEDG

I

IV

IS

20

Region Goods Market Money Market

Disequilibrium Output Disequilibrium Interest Rate

I ESG Falls ESM Falls

II EDG Rises ESM Falls

III EDG Rises EDM Rises

IV ESG Falls EDM Rises

21

Fiscal Policy

I0

IS1

E E11

i1

Interest Rate

Y0

E1

Income and Output (Y)

LM

IS

Y1 Y11

22

The Transmission Mechanism

The Transmission Mechanism

Step One Step Two

     Change in

aggregate demand results in adjustments in output and income.

Change in real money supply

Adjustments in the portfolio, leading to a change in asset prices and interest rates

Changes in interest rates lead to change in aggregate demand

23

Monetary and Fiscal Policy

LM1

E1

E1

i1

i0

Interest Rate

Y0

E

Income and Output (Y)

LM

IS

Y1

24

Policy Effects on Income and Interest Rates

Policy Equilibrium Income Equilibrium Interest Rate

Expansionary Monetary policy

Increase Decrease

Expansionary Fiscal Policy

Increase Increase

Note that expansionary policy (fiscal or monetary) is the policy that is aimed to increase income. Expansionary monetary policy, thus, includes increasing money supply in the economy, while expansionary fiscal policy involves increasing government spending and reducing taxes. We discuss these aspects in detail later chapters.

25

Crowding Out

I0

IS1

E E11

i1

Interest Rate

Y0

E1

Income and Output (Y)

LM

IS

Y1 Y11

LM1