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 Y and the equilibrium i in the
economy in the short run (with fixed prices)
• The goods market will be represented by the
IS curve (standing for investment-savings)
• The financial markets (money market) will be
represented by the LM curve (liquiditymoney)
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Hicks-Hansen model based on Keynes’ General Theory
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The goods market - IS curve
• Equilibrium condition Y = Z  C + I + G
• Investment will provide the link to the
financial markets
• Determinants of investment:
– If sales increase, producers might want to
increase their productive capacity Y
– If the rate of interest rate i increases,
producers find that borrowing to add new
capital becomes more expensive
+ -
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I  I(Y,i)
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• Equilibrium in the goods market becomes:
Y = C(Y-T)+I(Y,i) + G
• Basically
– When i
– When i
I
I
and Ye
and Ye
• The ZZ curve shifts 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 MPC + MPI and
the interest rate is included in the intercept
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Construction of the IS curve
Y=Z
Z
i
Y’e
i
i’
Ye
When the interest rate
increases, I (Y, i) drops
ZZ’(i’)
and the ZZ curve shifts
down. The economy
contracts from Ye to Y’e.
Y
E’
E
i
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ZZ(i)
IS
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 = C(Y-T)+I(Y, i) + G
• Definition: All the combinations of i and Y
such that the goods market is in equilibrium
i.e. the above equation is satisfied
• Shift of the IS: A change in any of the
exogenous variables in the equation will
cause IS to shift.
– Shift variables:
• c0 and I0 (confidence variables)
• T and G (policy - fiscal - variables)
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Expansionary fiscal policy: increase in G
Y=Z
Z
ZZ’(G+∆G)
ZZ (G)
∆G
Ye
Y
Y’e
i
E
i
E’
IS’
IS
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Ye
Y’e
Y
When G increases,
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
i
G
T
c0
I0
G
T
c0
I0
IS
Y
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The financial markets - LM curve
• Equilibrium condition1:
supply of money = demand for money
Ms = PYL(i) or Ms/P = YL(i)
(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
LM
E’
i1
i0
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M’d(Y1>Y0)
Md(Y0)
M/P
E
Y0
Y1
Y
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The LM curve
• Ms = PYL(i)
• Definition: All the combinations of i and Y
such that the financial markets (bonds and
money) are in equilibrium
• Shift of the LM curve: a change in the
money supply or a change in price or an
exogenous shift in the money demand
– An increase in the money supply ( or a decrease
in price) is expansionary
– A change in the velocity of money
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Expansionary monetary policy: an
increase in Ms
Ms M’s
i
i
LM
LM’
A
i0
i1
Md(Y0)
M/P
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A’
Y0
Y1
Y
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Shifts of LM
i
LM
Ms
P
V
Ms
P
V
Y
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