Goods and Financial Markets Together: The IS-LM Model

Goods and Financial Markets Together: The IS-LM Model

Goods and Financial Markets Together: The IS-LM Model The Goods Market and the IS Relation Equilibrium in the goods market exists when production, Y, is equal to the demand for goods, Z. In the simple model (in chapter 3), the interest rate did not affect the demand for

goods. The equilibrium condition was given by: Y C (Y T ) I G Investment, Sales (Y), and the Interest Rate (i) Now, we no longer assume I (investment) is constant We capture the effects of two factors affecting investment: The level of sales/income (+)

The interest rate (-) I I (Y ,i) The Determination of Output Taking into account the investment relation above, the equilibrium condition in the goods market becomes: Y C (Y T ) I (Y ,i) G

The Determination of Output 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.

Deriving the IS Curve The Effects of an Increase in the Interest Rate on Output An increase in the interest rate decreases the demand for goods at any level of output.

The IS Curve Shifts of the IS Curve An increase in taxes... Financial Markets and the LM Relation The interest rate is determined by the equality of the supply of and the demand

for money: M $ Y L (i) M = nominal money stock $YL(i) = demand for money $Y = nominal income i = nominal interest rate Real Money, Real Income, and the Interest Rate The LM relation: In equilibrium, the real money supply is equal to the real money demand, which

depends on real income, Y, and the interest rate, i: M Y L (i) P Recall: before, we had the same equation but in nominal instead of real terms (nominal income and nominal money supply). Dividing both sides by P (the price level) gives us the equation above.

Deriving the LM Curve The Effects of an Increase in Income on the Interest Rate Shifts of the LM Curve Shifts of the LM Curve An increase in money...

The IS and the LM Relations Together The IS-LM Model Equilibrium in the goods market (IS). Equilibrium in financial markets (LM). When the IS curve intersects the LM curve,

both goods and financial markets are in equilibrium. IS r e la tio n : Y C (Y T ) I (Y ,i ) G L M r e la tio n : M Y L (i) P Fiscal Policy, the Interest Rate and the IS

Curve Fiscal contraction: a fiscal policy that reduces the budget deficit. Reducing G or increasing T Fiscal expansion: increasing the budget deficit.

Increasing G or decreasing T Taxes (T) and government expenditures (G) affect the IS curve, not the LM curve. Fiscal Policy, the Interest Rate and the IS Curve The Effects of an Increase in Taxes Monetary Policy, the Interest Rate, and

the LM Curve Monetary contraction (tightening) refers to a decrease in the money supply. An increase in the money supply is called monetary expansion. Monetary policy affects only the LM curve, not the IS curve. Monetary Policy, the Interest Rate, and the LM Curve

The Effects of a Monetary Expansion Recent U.S. Monetary Policy Using a Policy Mix The Effects of Fiscal and Monetary Policy. Shift of IS Shift of LM

Movement of 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

German Unification and the German Monetary-Fiscal Policy Mix U.S. Money Supply during the Great Depression (1928-1936) U.S. Fiscal Policy during the Great Depression (1930-1947) The U.S. Recession of 2001

Mr. Greenspan:

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