Goods and Financial Markets Together: The IS-LM Model - PowerPoint PPT Presentation

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Goods and Financial Markets Together: The IS-LM Model. The Goods Market and the IS Relation. Equilibrium in the goods market exists when production, Y , is equal to the demand for goods, Z .

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Goods and Financial Markets Together: The IS-LM Model

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Goods andFinancial Markets Together:The IS-LM Model

The Goods Marketand the IS Relation

• Equilibrium in the goods market exists when production, Y, is equal to the demand for goods, Z.

• In the simple model (in chapter 3), the interest rate did not affect the demand for goods. The equilibrium condition was given by:

Investment, Sales (Y), and the Interest Rate (i)

• Now, we no longer assume I (investment) is constant

• We capture the effects of two factors affecting investment:

• The level of sales/income (+)

• The interest rate (-)

The Determination of Output

• Taking into account the investment relation above, the equilibrium condition in the goods market becomes:

The Determination of Output

Equilibrium in the Goods Market

The demand for goods is an increasing function of output. Equilibrium requires that the demand for goods be equal to output.

Deriving the IS Curve

The Effects of an Increase inthe Interest Rate on Output

An increase in the interest rate decreases the demand for goods at any level of output.

The IS Curve

Shifts of the IS Curve

An increase in taxes...

Financial Marketsand the LM Relation

• The interest rate is determined by the equality of the supply of and the demand for money:

M = nominal money stock\$YL(i) = demand for money\$Y = nominal incomei = nominal interest rate

Real Money, Real Income,and the Interest Rate

• The LM relation: In equilibrium, the real money supply is equal to the real money demand, which depends on real income, Y, and the interest rate, i:

Recall: before, we had the same equation but in nominal instead of real terms (nominal income and nominal money supply). Dividing both sides by P (the price level) gives us the equation above.

Deriving the LM Curve

The Effects of an Increase in Income on the Interest Rate

Shifts of the LM Curve

Shifts of the LM Curve

An increase in money...

The IS and the LM Relations Together

The IS-LM Model

Equilibrium in the goods market (IS).

Equilibrium in financial markets (LM).

When the IS curve intersects the LM curve, both goods and financial markets are in equilibrium.

Fiscal Policy, the Interest Rate and the IS Curve

• Fiscal contraction: a fiscal policy that reduces the budget deficit.

• Reducing G or increasing T

• Fiscal expansion:increasing the budget deficit.

• Increasing G or decreasing T

• Taxes (T) and government expenditures (G) affect the IS curve, not the LM curve.

Fiscal Policy, the Interest Rate and the IS Curve

The Effects of an Increase in Taxes

Monetary Policy, the Interest Rate, and the LM Curve

• Monetary contraction (tightening) refers to a decrease in the money supply.

• An increase in the money supply is called monetary expansion.

• Monetary policy affects only the LM curve, not the IS curve.

Monetary Policy, the Interest Rate, and the LM Curve

The Effects of a Monetary Expansion