Transcript Goods and Financial Markets1: IS-LM

Goods and Financial Markets1: IS-LM
• Goal: link the goods and the financial markets
into a more general model that will determine
the equilibrium and the equilibrium in the
economy
(with
prices)
• The goods market will be represented by the
curve (standing for investment-savings)
• The financial markets (money market) will be
represented by the
curve (liquiditymoney)
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1. The Hicks-Hansen model based on Keynes’ General Theory
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The goods market - IS curve
• Equilibrium condition
•
will provide the link to the
financial markets
• Determinants of investment:
– If
increase, producers
might want to increase their productive capacity by
investing in capital goods.
– If
, producers find that
borrowing to add new capital becomes more
expensive
I
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• Equilibrium in the goods market becomes:
Y=
• Basically
– When i
– When i
I
I
and Ye
and Ye
• The ZZ curve shifts now as the interest rate
changes and a multiplier effect takes place
– If MPI is the marginal propensity to invest out of new
income, assume that MPC + MPI < 1
– The slope of the ZZ curve is now
and
the interest rate is included in the intercept
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Construction of the IS curve
Z
When the interest rate
increases, I (Y, i) drops
and the ZZ curve shifts
down. The economy
contracts from Ye to Y’e.
i
Y’e
Ye
Y
i
i’
i
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Y’e
Ye
E and E’ correspond to 2
combinations of i and Y,
such that the good market
is in equilibrium.
Y
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The IS curve
• Y=
• Definition: All the combinations
i.e. the above equation is satisfied
• Shift of the IS: A change in any of the
in the equation will
cause IS to shift.
– Shift variables:
•
•
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(confidence variables)
(fiscal policy variables)
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Expansionary fiscal policy: increase in G
Y=Z
Z
ZZ (G)
Y
Ye
i
E
i
IS
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Ye
Y
When G increases
by ∆G, ZZ shifts
up and IS shifts to
the right.
An increase in T
would has the
opposite effect as it
is contractionary.
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Shifts of IS
Expansionary
i
G
T
c0
I0
Contractionary
G
T
c0
I0
IS
Y
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The financial markets - LM curve
• Equilibrium condition1:
supply of money = demand for money
Ms =
or Ms/P =
(Ms/P is the real money supply)
• It is clear that both LM and IS are relations
between i and Y
1. The bonds market is automatically in equilibrium when the
money market is in equilibrium
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Construction of the LM curve
Ms
i
i
i0
Md(Y0)
M/P
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Y0
Y1
Y
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The LM curve
• Ms =
• Definition: All the combinations of and
such that the
(
and
) are in equilibrium
• Shift of the LM curve: a change in the
money
or a change in
or an
exogenous shift in the money demand
– An
in the money supply ( or a
in price) is expansionary
– A change in the velocity of money
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Expansionary monetary policy: an
increase in Ms
Ms
i
i
A
i0
Md(Y0)
M/P
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LM
Y0
Y
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Shifts of LM
i
LM
Ms
P
V
Ms
P
V
Y
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The IS-LM model
Y=
M/P =
IS is
IS curve
LM curve
sloped and LM is
sloped, they will intercept in E
determining Y and i in equilibrium.
At that point, all three markets :
two financial markets and the goods market,
are
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The IS-LM graph
i
Y
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Problem # 4
IS-LM model:
C = 200+ .25YD
I = 150 + .25Y - 1000i
G = 250 and T = 200
(M/P)d = 2Y - 8000i
M/P = 1,600
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IS
LM
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a. Derive the IS curve: Y = C + I + G
Y = 200 + .25Y- .25T + 150 + .25Y - 1000i + 250
= 550 + .5Y - 1000i
Y - .5Y = 550 - 1000i
Y (1 - .5) = 550 - 1000i
Y = [1/.5] (550 -1000i)
multiplier = 2
IS curve: Y = 1100 - 2000i
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b. Derive the LM curve: YL(i) = M/P
2Y - 8000i = 1600
8000i = 2Y - 1600
LM curve: i = Y/4000 - .2
c. Solve IS-LM for equilibrium Y
Y = 1100 -2000i
= 1100 - 2000(Y/4000 - .2)
= 1100 - .5Y + 400
1.5Y = 1500
so Y = 1000
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d. i = Y/4000 - .2
= 1000/4000 - .2
= .25 - .2 = .05 so i = 5%
e. Replace equilibrium Y and i into C and I
C = 200 + .25*1000 - .25*200 = 400
I = 150 + .25*1000 - 1000*.05 = 350
G = 250
So Y = 400 + 350 + 250 = 1000
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Fiscal Policy
• Instruments:
• Curve affected:
• Effect:
Expansionary: when (G-T)
or G
or T
IS shifts to the
Contractionary: when (G-T)
or G
or T
IS shifts to the
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A fiscal expansion
i
LM
ie
The economy moves
along the LM curve
from A to A’
A
IS
Ye
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Y
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Mechanics of fiscal expansion
Goods market effects
As G
Y=
too immediately
Then C=
and I =
also
Multiplier effect: at same i, Y reaches a higher
level as IS shifts to the right
Financial markets effects
As Y
the demand for money M =
and the
ward shift in Md results in a
i,
but this is a movement along the
curve to A’.
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Effect on investment
As i increases, investment is
.
So there are 2 opposite effects on investment
as Y increases I
as i increases I
It means that the overall expansion due to the
increase in G will be
by the impact of
the increase in the interest rate on investment.
There is some
of private investment
due to the increase in government spending.
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Expansionary
Fiscal
Policy
Y=Z
Z
ZZ (G)
∆G
i
Ye
Ms
LM
i
i’
i’
i
i
Md
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Y
Y”
IS
M/P
Ye
Y’e
Y
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Net effect of increase in G on investment
I
1.
Using investmt funct
as Y increases
I
as i increases I
Net effect is ambiguous
I
2.
Using equil condition
as Y increases
Sp
as G increases
(T - G)
Net effect is ambiguous
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Problem # 5 cont.
g. A fiscal expansion: G increases to 400
New IS curve: Y = 700 + .5Y - 1000i
Y = [1/.5] (700 - 1000i)
= 1400 - 2000i
Same LM curve: i = Y/4000 - .2
Solve: Y = 1400 - 2000(Y/4000 - .2)
1.5Y = 1800 so Y = 1200
Replace in LM and we get i = .10 or 10%
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Calculate the corresponding equilibrium for C & I
C = 200 + .25Y - .25T = 200 + 300 - 50 = 450
I = 150 + .25Y - 1000i = 150 + 300 - 100 = 350
Y = C + I + G = 450 + 350 + 400 = 1200
Impact of fiscal expansion:
both Y and i increase.
C (a function of Y) increases too.
I increases when Y increases and decreases when i
increases (ambiguous results overall).
With these data, I does not change as the two
effects
neutralize each other.
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Monetary policy
• Instrument:
• Curve affected:
• Effect:
Expansionary when Ms increases
LM shifts to the
Contractionary when Ms is cut
LM shifts to the
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A monetary contraction
i
LM
ie
A
IS
Ye
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Y
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Mechanics of a monetary contraction
• Open market
of bonds
• Suppose P=1 constant - so monetary contraction
in
terms is equivalent to a
terms one.
Financial market effects
As Ms drops, i
- money market effect.
Goods market effects
As i increases, investment I = I(Y,i) is
affected and Y =
.
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Effect on investment
Unambiguous: as Y drops and
i increases,
investment can only
.
Note that the money demand will shift to the
left as Y drops dampening the extent of the
increase in the interest rate on the fall of I
and subsequently on the fall of Y.
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A monetary contraction
M’s
i
Ms
i
IS
LM
i
Md
M/P
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Ye
Y
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Problem #5 cont.
g. Monetary expansion: M/P increases to 1840
Same IS curve: Y = 1100 - 2000i
New LM curve: 2Y - 8000i = 1840
i = Y/4000 - 1840/8000
i = Y/4000 - .23
Solve the IS-LM system:
Y = 1100 - 2000(Y/4000 - .23)
Y = 1100 - .5Y - 460
1.5 Y = 1560 so Y = 1040
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Replace in LM:
i = 1040/4000 - .23 so i = .03 or 3%
Solve for C and I
C = 410 and I = 380
A monetary expansion reduces i
and increases Y
Thus C (function of Y) increases
and I (function of Y and of i) increases
unambiguously.
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Policy Mix 1
• To maximize the
expansionary (or
contractionary) impact
on the economy, use
both expansionary
monetary and
expansionary fiscal
policy (or both
contractionary).
i
LM
IS
Y
Rational:
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Policy Mix 2
• To dampen the
inflationary
impact of an
expansionary
fiscal policy, use
at the same time
contractionary
monetary policy.
Rational:
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i
LM
IS
Y
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