Transcript IS-LM

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The Circular Flow of Spending
and Income, “Multipliers”,
“IS-LM
Lecture 7
The Circular Flow-in a closed economy
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Excise Taxes
Spending on
Purchases
of Goods
Saving
Wages, Profits, Rents
Payroll & Income Tax
Production
of Goods
The Circular Flow-in a closed economy
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Excise Taxes
Spending on
Purchases
of Goods
Saving
Wages, Profits, Rents
Payroll & Income Tax
Production
of Goods
The Circular Flow-in an open economy
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Imported Goods
Export Demands
Excise Taxes
Spending on
Purchases
of Goods
Saving
Production of
Domestic Goods
Wages, Profits, Rents
Payroll & Income Tax
The Multiplier
 The
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“Multiplier” represents feedback
effects within the circular flow of a
change in a previous assumption
 Obviously, feedback effects are greater
the less leakage there is in the circular
flow
The “IS” Curve
 The
IS Curve is the name given
equilibrium set of points denoting
– total spending corresponding to each
interest rate,
– for any given fiscal policy and
international setting
 GNP = C+I+X-M +G
= GNP ( G, T, i, GNPW )
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The Reduced Forms of the 7
Behavioral Equations
 C=C
( G, T, i, GNPW )
 I = I ( G, T, i, GNPW )
 M = M ( G, T, i, GNPW )
 X = X ( G, T, i, GNPW )
 GNP = C+I+X-M +G
= GNP ( G, T, i, GNPW )
 YD = GNP - T
 RP = RP ( GNP) = RP( G, T, i, GNPW )
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The GNP Reduced Form Equation
is a Useful Summary
GNP
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= C+I+X-M +G= GNP ( G, T, i, GNPW )
Solve it for GNP=f(i) in 2 dimensions
yields the IS curve
i=
INTEREST
RATE
GNP2=
GNP(G2,T1)
GNP1=
GNP(G1,T1)
GNP=NATIONAL SPENDING/OUTPUT
The “LM” Curve
 Previously,
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we described interest rates as
being a policy decision made by the Federal
Reserve in reaction to the level of economy
activity : i = f ( GNP). How they achieved
this by manipulating reserves and money was
implicit in the function.
 We could go behind this to look at private
demand for money as a function of interest
rates and income : the LM Curve
The “LM” Curve
 Private
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demand for money as a function of
interest rates and income : the LM Curve
 Define “Money” and its portfolio alternatives
 Motivations to hold money
 Motivations to hold bonds, stocks, durable
goods
 Combine to motivate demand for money:
– Positively correlated with spending
– Negatively correlated with interest rates
The “LM” Curve
 Solve
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M/p= Liquidity = f( i , GNP) for i
 Plot it in 2 dimensions ( i vs GNP ) for any
given level of M/p
 This is the “LM” Curve showing points of
equilibrium (Liquidity Demanded = Money
Supply):
– For a given M/p, higher GNP encourages
money holding, thus equilibrium requires a
higher i to discourage/offset the GNP
stimulus
Private Motivation to Hold Money
 Keynes’:
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current transactions, precautionary
(possible future transactions), speculative
(maximizing return on all assets in uncertain world)
 Zero sum game: your income and accumulated
wealth in by the end of each period must be
consumed or saved; if saved, a form of saving must
be chosen
 Your choice of “money” as the savings vehicle is a
choice against all other options, and is made on the
basis of relative tangible and intangible yields and
their risks.
Why Is There Such a Focus on “Money?”
Rather Than Other Assets?
 1.
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Tradition: it was originally distinctive
because it paid no tangible yield and was
the only “perfectly liquid” asset.
 2. The central bank was thought to have
greater control over its supply.
Transactions demand
 Classic
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Tobin-Baumol model
– per capita M=sq rt (tc*per cap inc / 2i)
– M=N * sq rt (tc* Y / N / 2i)
– log(M)= .5* (log(N)+log(Y) +log(tc)
-log(i)) - log(2)
 Be careful about defining Y, the spending measure
for private holding: it’s not GNP. Why?
 Remember this is only the transactions demand
component. Note consensus long-run spending
elasticity is close to 1.
Precautionary Demand
 Demand
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to meet emergencies or other
needs for large purchases where liquidity
is an advantage?
 How do you think these would relate to
Y, i ?
Speculative Demand
 A desire
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to hold money even with a known low
nominal return and only the risk of inflation, versus
other financial assets that have capital risk(due to
changing interest rates) as well, or versus real goods
that are illiquid/ expensive to sell to raise funds.
 Explain capital risk on bonds: why the price varies
with the market rate after original issue.
 Explain risk-return tradeoff.
 Ask and explain how speculative demand would
relate to income, and to interest rates.
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The “LM” Curve
 For
a given M/p, higher GNP encourages money
holding, thus equilibrium requires a higher i to
discourage/offset the GNP stimulus
i=
Interest
Rate
i
=L( M/p, GNP )
GNP = National Spending / Output
The “LM” Curve is a Hidden
Piece of the First Model
 Private
Demand for Money
– M/p (real demand) = f ( i , GNP)
– or, i = f ( M/p , GNP )
 The Fed Reactions
– Central Bank Supply of Money
– M/p = g ( GNP)
 If Demand=Supply= ( M / p )
 Then, i = f ( g(GNP) , GNP) = f ( GNP ), the
Fed reaction function of the First Model
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Elementary Monetarism
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 velocity=GNP/M1
 GNP=P *
T(Real Transactions)
 thus v=P * V / M
 or M * v = P * T, known as the quantity equation,
the core of the quantity theory of money, whose key
conclusion is P = M *(Y/v) and strict monetarism
asserts Y, v are fixed in equilibrium
 but velocity is not fixed; rather it is sensitive to
interest rates
The Velocity of Money (M1)
vs. the Treasury Bill Rate
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(percent)
(GDP/M1)
8.5
16
8
14
7.5
12
10
7
8
6.5
6
00
19
98
:0
1:
00
1:
:0
96
19
19
94
:0
1:
00
92
19
19
19
19
19
19
19
90
0
88
5
86
2
84
5.5
82
4
80
6
Money Velocity- GDP/MI (left scale)
Three Month Treasury Bill Rate (right scale)