#### Transcript Mankiw 6e PowerPoints

CHAPTER # 6 IS-LM MODEL slide 0 In this chapter, you will learn… the IS curve, and its relation to the Keynesian cross the LM curve, and its relation to the theory of liquidity preference how the IS-LM model determines income and the interest rate in the short run when P is fixed slide 1 Introduction Hicks presented the concept of IS curve in 1937 According to him, corresponding to equilibrium level of NI where I=S, there is some particular rate of interest. In other words hicks established the relationship between Y and i where S = I, so this relationship was given the name as Investment and saving curve (IS curve) slide 2 Definition IS Curve is a curve which shows different combinations of rate of interest (i) and level of NI (Y) where saving (S) are equal to Investment (I ). slide 3 Assumption of IS curve Y= C+I where C= C0+ cY, & I = I0 - Vi V= slope of investment curve which is affected by the changes in the rate of interest S= f(Y), S= -S0 + sY I= f(Y) Price level does not change Wages remain the same slide 4 Derivation of IS curve We know that Y=C+ I Putting the value of C & I in the equation So Y = C0 + cY +I0 –Vi Y - cY = C0 + I0 – Vi Y(1-c) = C0 + I0 – Vi Y= C0 + I0 – Vi 1-c Y = 1 (C0+I0-Vi) IS equation (1-c) slide 5 Numerical explanation of IS curve Suppose C= 100 + 0.5Y, I= 100 – 10i Putting them in IS equation Y= 1 (100 +100 -10i), (1-0.5) Y = 200-10i , 0.5 Y= 1 (200 -10i) (1-0.5) Y = 200- 10i 0.5 0.5 SO Y = 400 - 20i IS equation slide 6 Example….. Now assuming different interest rates, we get different values of Y where I=S, Taking i= 5% we have Y = 400 – 20i putting the value of i Y= 400 – 20(5%),Y= 400 -20(5/100), Y = 399 So C= 100 +0.5(399), C= 299.5 S= Y-C 399-299.5 S= 99.5 I= I0-Vi I=100-10(5%) Thus we have i Y 5% 399 I= 99.5 S 99.5 I 99.5 slide 7 The Keynesian Cross A simple closed economy model in which income is determined by expenditure. Notation: I = planned investment E = C + I + G = planned expenditure Y = real GDP = actual expenditure slide 8 IS Curve: Graphical Y E r E =C +I +G I E Y E =C +I +G I r Y1 Y Y2 r1 r2 IS Y1 Y2 Y slide 9 Why the IS curve is negatively sloped A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending (E ). To restore equilibrium in the goods market, output (actual expenditure, Y ) must increase. slide 10 Shifts of the IS Curve The inverse relation between r and Y is the IS curve r r1 Y For any particular value of r, such as r1, Y increases if There is an increase in G or in autonomous C or I, or if There is a decrease in T Y1 IS1 Y2 IS2 Y Therefore, these changes shift the IS curve to the right. slide 11 THE MARKET FOR LOANABLE FUNDS Financial markets coordinate the economy’s saving and investment in the market for loanable funds. Loanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption. slide 12 Supply and Demand for Loanable Funds The supply of loanable funds comes from people who have extra income they want to save and lend out. The demand for loanable funds comes from households and firms that wish to borrow to make investments. The market for loanable funds is the market in which those who want to save supply funds and those who want to borrow to invest demand funds. slide 13 Interest rate for Loanable Funds The interest rate is the price of the loan. It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving. The interest rate in the market for loanable funds is the real interest rate. slide 14 Figure 1 The Market for Loanable Funds Interest Rate Supply 5% Demand 0 $1,200 Loanable Funds (in billions of dollars) slide 15 Copyright©2004 South-Western IS curve and Loanable funds market The IS curve maps the relationship between r and Y for the loanable funds market in equilibrium. • Suppose Y increases from Y1 to Y2. This raises savings from S(Y1) to S(Y2) resulting in a lower equilibrium interest rate. r • The IS curve maps out this relationship between the lower interest rate and increased income. r S (Y1) S (Y2) r1 r1 r2 r2 I I IS Y1 Y2 Y slide 16 The Theory of Liquidity Preference Keynes developed the theory of liquidity preference in order to explain what factors determine the economy’s interest rate. According to the theory, the interest rate adjusts to balance the supply and demand for money. slide 17 The Theory of Liquidity Preference Equilibrium in the Money Market According to the theory of liquidity preference: The interest rate adjusts to balance the supply and demand for money. There is one interest rate, called the equilibrium interest rate, at which the quantity of money demanded equals the quantity of money supplied. slide 18 HOW FISCAL POLICY INFLUENCES AGGREGATE DEMAND Fiscal policy refers to the government’s choices regarding the overall level of government purchases or taxes. Fiscal policy influences saving, investment, and growth in the long run. In the short run, fiscal policy primarily affects the aggregate demand. slide 21 Changes in Government Purchases When policymakers change the money supply or taxes, the effect on aggregate demand is indirect—through the spending decisions of firms or households. When the government increases or decreases its own purchases of goods or services, it shifts the aggregate-demand curve directly. slide 22 Changes in Taxes When the government cuts personal income taxes, it increases households’ take-home pay. Households save some of this additional income and spend some of it on consumer goods. Increased household spending shifts the aggregate-demand curve to the right. slide 23 LM Curve Introduction according to Keynes, in money market equilibrium takes place at the rate of interest where Md=Ms. From this idea Hicks presented the concept of LM curve according to Hicks, corresponding to such rate of interest where Md=Ms there is some particular level of NI. slide 24 Cont`d Thus LM curve establishes a relationship between rate of interest and NI through Md & Ms. Where L represent the demand for money and M represent the supply of money slide 25 Definition of LM curve The LM curve is a graph of all combinations of r (rate of interest) and Y (NI) that equate the supply of money (Ms) and demand for money (Md). This direct relation between r and Y is the LM Curve. slide 26 Numerical explanation NI will be in equilibrium where Md=Ms While Md has two components i.e. Mtd & Msd Where Mtd = kY , Msd= mo - mi where m0 represent Msd at zero rate of interest m is the slope of Msd curve, and i is the rate of interest. slide 27 Numerical explanation….. Now Suppose Mtd =0.25Y, Msd =124 -200i, Ms =300 So MD = 0.25Y +124 -200i , & Ms= 300 As Ms=Md so 300= 0.25Y+ 124 - 200i 300-124=0.25Y -200i 176=0.25Y-200i 0.25Y =176 +200i Y= 704 + 800i LM equation slide 28 Numerical explanation…. Suppose i= 5% Y= 704 +800i Y = 704 +800(5%) So Mtd = 0.25Y Mtd= 0.25(744) & Msd= 124 -200(5%) Msd= 124 -10 We know that Md= Mtd + Msd Y=744 Mtd= 186 Msd=114 Md =186+114=300 Thus Md= Ms =300 i Y Mtd + Msd = Md Ms 5% 744 186 + 114 = 300 300 Similarly we can get different value of Y where Md=Ms slide 29 Deriving the LM curve (a) The market for r real money balances (b) The LM curve r LM r2 r2 L (r , Y2 ) r1 r1 L (r , Y1 ) Ms M/P Y1 Y2 Y slide 30 Why the LM curve is upward sloping An increase in income raises money demand. Since the supply of real balances is fixed, there is now excess demand in the money market at the initial interest rate. The interest rate must rise to restore equilibrium in the money market. slide 31 How M shifts the LM curve (a) The market for r real money balances (b) The LM curve r LM2 LM1 r2 r2 r1 r1 L ( r , Y1 ) M2/P M1/P M/P Y1 Y slide 32 Shifts of the LM Curve We see that r decreases when either P or Y decreases, or M increases, or Autonomous money demand LM0 r0 LM1 r1 decreases Therefore, the LM curve shifts right if there is an increase in M or a decrease in either P or autonomous money demand. Y0 slide 33 Exercise: Shifting the LM curve Suppose a wave of credit card fraud causes consumers to use cash more frequently in transactions. Use the liquidity preference model to show how these events shift the LM curve……???? slide 34 IS=LM: The Short Run Equilibrium Given our IS and LM equation we can now determine the short run equilibrium interest rate and output • By mapping out the relationship between Y and r when the goods market is in equilibrium we get the IS curve. • By mapping out the relationship • between Y and r when the money market is in equilibrium we get the LM curve. When we set IS=LM we can solve for the equilibrium levels of r and Y. This represents simultaneous equilibrium in the goods market (or loanable funds market) and the money market. r LM r* IS Y* Y slide 35 The Big Picture Keynesian Cross Theory of Liquidity Preference IS curve LM curve IS-LM model Agg. demand curve Agg. supply curve Explanation of short-run fluctuations Model of Agg. Demand and Agg. Supply slide 36 Recap: Shifts of IS and LM Curves The IS curve shifts right if G increases, or autonomous C or I increases, or T decreases The LM curve shifts right if M increases, or P decreases, or Autonomous money demand decreases. r r LM LM0 LM1 IS0 IS1 Y IS Y slide 37 Chapter Summary 1. Keynesian cross basic model of income determination takes fiscal policy & investment as exogenous fiscal policy has a multiplier effect on income. 2. IS curve comes from Keynesian cross when planned investment depends negatively on interest rate shows all combinations of r and Y that equate planned expenditure with actual expenditure on goods & services slide 38 Chapter Summary 3. Theory of Liquidity Preference basic model of interest rate determination takes money supply & price level as exogenous an increase in the money supply lowers the interest rate 4. LM curve comes from liquidity preference theory when money demand depends positively on income shows all combinations of r and Y that equate demand for real money balances with supply slide 39 Chapter Summary 5. IS-LM model Intersection of IS and LM curves shows the unique point (Y, r ) that satisfies equilibrium in both the goods and money markets. slide 40 slide 41