Principles of Economics

1. Principles of Economics Session 14

2. Topics To Be Covered • Equilibrium of the Goods Market • Equilibrium of the Money Market • The IS-LM Model • The AS-AD Model

3. LM Curve IS Curve IS-LM Model AS-AD Model Explanation of Short-Run Fluctuations The Big Picture Keynesian Cross Liquid Preference

4. Output=Demand Demand Demand 45° 0 Output The Keynesian Cross

5. Planned Expenditure = AD: $1000 Output = AS: $1000 Planned Inventory=Planned Investment: $200 Planned Consumption: $800 Planned Saving: $200 Unplanned Inventory: $0 Income: $1000 Equilibrium of the Goods Market

6. Demand 1000 Demand(Planned Expenditure) Output 45° 0 1000 S Planned Saving and Investment I 200 0 Output 1000 Equilibrium of the Goods Market Output=Demand, so the goods market is at equilibrium. I = S

7. Planned Expenditure = AD: $800 Output = AS: $1000 Planned Inventory=Planned Investment: $200 Planned Consumption: $600 Planned Saving: $400 Unplanned Inventory: $200 Income: $1000 Contraction of the Goods Market

8. Output＞Demand, so the goods market tends to contract. Demand 800 Demand(Planned Expenditure) Output 45° 0 1000 Equilibrium output S 400 S ＞ I Planned Saving and Investment I 200 0 Output 1000 Contraction of the Goods Market

9. Planned Expenditure = AD: $1200 Output = AS: $1000 Planned Inventory=Planned Investment: $200 Planned Consumption:$1000 Planned Saving: $0 Unplanned Inventory: - $200 Income: $1000 Expansion of the Goods Market

10. Demand 1200 Demand(Planned Expenditure) Output ＜Demand, the goods market tents to expand. Output 45° 0 1000 Equilibrium output S Planned Saving and Investment S ＜I I 200 0 Output 1000 Expansion of the Goods Market

11. Equilibrium of the Goods Market ＞ ＝ ＜ When the goods market is at equilibrium, planned investment equals planned saving.

12. The IS Curve • The IS curve is a graph of all combinations of interest (r) and output (Y) that result in goods market equilibrium. • When the goods market is at equilibrium Output=Planned Expenditure Planned Investment = Planned Saving

13. E =Y E E2=C +I(r2)+G I r  I Y  E Y1 Y2 r  Y r2 Y Y1 Y2 Deriving the IS curve E1=C +I(r1)+G r1 IS Curve

14. Deriving the IS Equation • I = investment • r = interest rate • e ＞ 0, d ＞ 0

15. The Downward-Sloping IS Curve • A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending. • To restore equilibrium in the goods market, output must increase. Interest rate falls Investment spending increases Output increases

16. The Downward-Sloping IS Curve

17. Fiscal Policy and the IS Curve At any value r, increase in government purchase (G) results in more expenditure and consequently more output (Y), so the IS curve shifts to the right.

18. E =Y E E2=C +I+G2 G Y2 Y Y1 r IS2 IS1 Y2 Y Y Y1 Fiscal Policy and the IS Curve E1=C +I+G1 r1

19. The Demand for Money(The Liquid Preference) • Transaction demand for moneyThe needs or desires of individuals or firms to make purchases on short notice without incurring excessive costs. • Speculative demand for moneyAn attitude that holding money over short periods is less risky than holding stocks or bonds.

20. The Transaction Demandfor Money • The transactions demand for money is based on the desire to facilitate transactions. • It mainly depends on the income, so its function is:

21. The Speculative Demandfor Money • The speculative demand for money is based on the desire to make wise decisions to invest in securities such as bonds. • It mainly depends on the interest, so its function is:

22. The Speculative Demandfor Money • When the interest is high, the bond price is low. Usually people will guess that the bond price is to rise, so they purchase bonds, thus having less money in hand. Purchasingbonds highinterestrates Lowbondprices Lessmoneyin hand

23. The Speculative Demandfor Money • When the interest is low, the bond price is high. Usually people will expect that the bond price is to fall, so they sell the bonds they own. Consequently they have more money in hand. Moremoneyin hand Sellingbonds Lowinterestrates Highbondprices

24. L1=L1(Y) r r L=L1+ L2 L2=L2(r) m m Demand for Money

25. Equilibrium of the Money Market • When the money market is at equilibrium, the demand for money (L) should be equal to the supply of money (m). • The money supply is controlled by the central bank.

26. m1 E r1 m1 Equilibrium of the Money Market r L When money demand and supply equal, the money market is at equilibrium m

27. The LM Curve • The LM curve is a graph of all combinations of interest (r) and output (Y) that result in money market equilibrium. • When the money market is at equilibrium, the demand for and the supply of real money balances.

28. LM Curve L2 r2 r2 E2 E2 Y2 Deriving the LM Curve The Market for Real Money Balances The LM Curve r r L1 r1 r1 E1 E1 m Y Y1 m1

29. Deriving the LM Equation • m = supply of real money • r = interest rate • k＞ 0, h ＞ 0

30. The Upward-Sloping LM Curve • 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. Demand for money increases Interest raterises Outputincreases

31. The Upward-Sloping LM Curve

32. Monetary Policy andthe LM Curve At any value r, increase in output requires more money supply to maintain the interest rate constant, so the LM curve shifts to the right.

33. L2 LM2 E2 E2 Y2 m2 Monetary Policy and the LM Curve The Market for Real Money Balances The LM Curve r r LM1 L1 r1 r1 E1 E1 m Y Y1 m1

34. The IS-LM Model The IS-LM model is a graph showing the short-run equilibrium with the combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods and money markets.

35. Equilibrium interest rate Equilibrium output The IS-LM Model r LM E IS Y

36. A B D Equilibrium interest rate C F G Equilibrium output The IS-LM Model r LM For A, B, and C, I＜S. E For D, F, and G, I＞S. IS Y

37. A B Equilibrium interest rate C D F G Equilibrium output The IS-LM Model r For A, B, and C, L＜M. LM For D, F, and G, L＞M. E IS Y

38. Equilibrium interest rate Equilibrium output The IS-LM Model r LM L＜MI ＜ S L＜MI ＞ S L＞MI ＜ S E L＞MI ＞ S IS Y

39. The Policy and the IS-LM Model • Policymakers can affect macroeconomic variables with • fiscal policy: G and/or T • monetary policy: M • The IS-LM model can be applied to analyze the effects of these policies.

40. r2 IS2 Y2 The Fiscal Policy andthe IS-LM Model r LM r1 IS1 Y Y1

41. LM2 r2 Y2 The Monetary Policy andthe IS-LM Model r LM1 r1 IS Y Y1

42. Interaction between Monetary and Fiscal Policy • Monetary policymakers may adjust Min response to changes in fiscal policy, or vice versa. • Such interaction may alter the impact of the original policy change.

43. Monetary Policy in Response to Fiscal Policy • Suppose the government increases G. • Possible central bank’s responses: • hold M constant • hold r constant • hold Y constant • In each case, the effects of the Gare different.

44. r2 IS2 Y2 Response 1: Hold M Constant r LM1 r1 IS1 Y Y1

45. LM2 r2 IS2 Y3 Y2 Response 2: Hold r Constant r LM1 r1 IS1 Y Y1

46. LM2 r3 r2 IS2 Y2 Response 3: Hold Y Constant r LM1 r1 IS1 Y Y1

47. Classical situation where fiscal policy has no positive effect. Keynesian trap or liquid preference trap, over where fiscal policy works most efficiently IS4 IS3 IS1 IS2 Keynesian Trap r LM Y

48. r LM(P2) LM(P1) r2 r1 P (M/P) IS  LM Y Y1 Y2 P  r P2  I P1  Y AD Y Y2 Y1 Deriving the AD curve

49. r LM(M2/P1) r2 M LM  r Y Y2 P  I  Y at each P AD2 Y Y2 Monetary Policy and AD Curve LM(M1/P1) r1 IS Y1 P1 AD1 Y1

50. r G IS IS2 Y Y2 P  Y at each P AD2 Y Y2 Fiscal Policy the AD curve LM r2 r1 IS1 Y1 P1 AD1 Y1