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Chapter 5: IS - LM Model, image, Govt. can use a mix of fiscal and…
Chapter 5: IS - LM Model
IS Curve:
- same factors that shift AE curve will shift IS curve
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- In a closed economy Δs in autonomous C, I, G or T (given i) shifts the IS curve left/right
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- In an open economy, Δs in autonomous X and M (given i) shifts IS curve left/right
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- Δs in i result in movements along the IS curve
higher i = movement up
lower i = movement down
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- IS relation follows from goods market equilibrium
∴ any point on downward sloping IS curve corresponds to equilibrium in the goods market
Equilibrium in the goods market is the condition where production(Y) = demands for goods (Z)
An increase in Y leads to an increase in disposable income, which leads to an increase in consumption.
An increase in Y also leads to an increase in investment
↑ This leads to an increase in the demand for goods
How interest affects IS curve:
- An increase in interest rate decreases the demand for goods at any level of output & decreases output (demand curve shifts down)
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- A decrease in interest rate increases the demand for goods at any level of output & increases output (demand curve shifts up)
How to describe in tests: "The increase in the interest rate decreases investment. The decrease in investment leads to a decrease in output, which further decreases consumption and investment, through the multiplier effect."
OR
"The decrease in the interest rate increases investment. The increase in investment leads to an increase in output, which further increases consumption and investment, through the multiplier effect"
- The change on the X-axis caused by the increase on the Y-axis is the value of the multiplier effect.
- Decrease in consumer confidence would decrease consumption given disposable income and vice versa
Investment
Investment function becomes more complex:
New formula: I = b0 + b1Y - b2i
- b0 is autonomous investment
- b1 is income elasticity of investment (fraction of a change in Y that will change investment)
- b2i captures relationship between investment and interest rates. Investment and interest rates are inversely related
- b2 is elastcity of investment, tells how much investment changes when the interest rate changes
The level of investment in an economy depends on two factors:The level of sales/production:
- e.g A firm facing an increase in sales will feel the need to buy more equipment (i.e invest in the firm). A firm that has a low level of sales will not be thinking of investing at all.
An increase in sales/production increases investment
A decrease in sales/production decreaes investmentThe interest rate:
- When interest rates are high, a firm is less likely to borrow money for investment purposes. When interest rates are low, a firm is more likely to borrow money for investment purposes
The higher the interest rate, the lower the level of invesment
The lower the interest, the higher the level of investment
LM function
Real money supply = Real money demand
M/P = d0 + d1Y/P - d2i
- d0 is autonomous demand for money
- d1: income elasticity of money demand, measures the change in Md for a given change in Y
- d2: interest elastcitiy of money demand, measures the change in Md for unit change in the interest rate
d2i = (d0-M) + d1Y
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Financial Markets and LM relation
- An increase in nominal income, increases the demand for money
- An increase in interest rate decreases the demand for money
- LM function follows from financial market equilibrium
∴ any point on horizontal LM curve corresponds to equilibrium in financial markets
Fiscal Policy
Fiscal policy involves changing budget deficits due to changes in govt. spending or taxes (essentially changes in exogenous variables)
- Fiscal Contraction/Consolidation: reduction in budget deficit due to an increase in taxes or govt. spending
- Fiscal expansion: increase in budget deficit due to a decrease in taxes or govt. spending
How to answer questions about the effects of changes in policy:
- Ask how the change affects equilibrium in the goods market and how it affects equilibrium in the financial markets. Put another way: Does it shift the IS curve and/ or the LM curve, and, if so, how?
- Characterize the effects of these shifts on the intersection of the IS and the LM curves. What does this do to equilibrium output and the equilibrium interest rate?
- Describe the effects in words
See pg 120 and 121 of txt book
Monetary policy
Monetary policy refers to how a central bank changes the interest rates, money supply to affect money demand and ∴output
Monetary expansion: increase in money supply caused by a decrease in interest rate.
Monetary contraction: decrease in money supply caused by an increase in interest rate.
- Change in interest rate by central bank DOES NOT shift the IS curve, it rather shifts the LM curve up or down
- Lower Interest rate: increases investment, ∴ increases demand and output. Disposable income also increases and ∴ consumption increases
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- Higher interest rate: decreases investment, ∴decreases demand and output. Disposable income decreases and ∴ consumption decreases
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