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The Keynesian Framework and the ISLM Model. Determination of Output. Keynesian ISLM Model assumes price level is fixed Aggregate Demand Y ad = C + I + G + NX Equilibrium Y = Y ad Consumption Function C = a + ( mpc  Y D ) Investment 1. Fixed investment

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determination of output
Determination of Output

Keynesian ISLM Model assumes price level is fixed

Aggregate Demand

Yad = C + I + G + NX

Equilibrium

Y = Yad

Consumption Function

C = a + (mpcYD)

Investment

1. Fixed investment

2. Inventory investment

Only planned investment is included in Yad

keynesian cross diagram
Assume G = 0, NX = 0, T = 0

Yad = C + I = 200 + .5Y + 300 = 500 + .5Y

Equilibrium:

1. When Y > Y*, Iu > 0 Y to Y*

2. When Y < Y*, Iu < 0 Y to Y*

Keynesian Cross Diagram
analysis of figure 3 expenditure multiplier
Analysis of Figure 3: Expenditure Multiplier

I = + 100 Y/I = 200/100 = 2

1

Y = (a + I) 

1 – mpc

A = a + I = autonomous spending

Conclusions:

1. Expenditure multiplier = Y/A = 1/(1 – mpc) whether change in A is due to change in a or I

2. Animal spirits change A

analysis of figure 5 role of government
Analysis of Figure 5: Role of Government

G = + 400, T = + 400

1. With no G and T, Yd = C + I = 500 + mpc Y = 500 + .5Y, Y1 = 1000

2. With G, Y= C + I + G = 900 + .5Y, Y2 = 1800

3. With G and T, Yd = 900 + mpc  Y – mpc T = 700 + .5Y, Y3 = 1400

Conclusions:

1. GY; TY

2. G = T = + 400, Y 400

role of international trade
NX = +100,

Y/NX = 200/100 = 2 = 1/(1 – mpc) = 1/(1 – .5)

Role of International Trade
is curve
IS Curve

IS curve

1. iINX, Yad, Y

Points 1, 2, 3 in figure

2. Right of IS: Y > YadY to IS

Left of IS: Y < YadY to IS

lm curve
LM curve

1. Y, Md, i Points 1, 2, 3 in figure

2. Right of LM: excess Md, i to LM Left of LM : excess Ms, i to LM

LM Curve
islm model
ISLM Model

Point E, equilibrium where Y = Yad (IS) and Md = M s (LM )

At other points like A, B, C, D, one of two markets is not in equilibrium and arrows mark movement towards point E

shift in the is curve
Shift in the IS Curve

1. C: at given iA, Yad, YIS shifts right

2. Same reasoning when I, G, NX, T

shift in the lm curve from a rise in m d
Shift in the LM Curve from a Rise in M d

1. M d: at given YA, i in panel (b) and (a) LM shifts to the left

effectiveness of monetary and fiscal policy
Effectiveness of Monetary and Fiscal Policy

1. M d is unrelated to ii, M d = M s at same YLM vertical

2. Panel (a): G, IS shifts right i, Y stays same (complete crowding out)

3. Panel (b): M s, Y so M d, LM shifts right iY

Conclusion: Less interest sensitive is M d, more effective is monetary policy relative to fiscal policy

m s vs i targets when is unstable
1. IS unstable: fluctuates from IS' to IS''

2. i target at i*: Y fluctuates from YI' to YI''

3. M target, LM = LM*: Y fluctuates from YM' to YM''

4. Y fluctuation is less with M target

Conclusion: If IS curve is more unstable than LM curve, M target is preferred

Ms vs. i Targets When IS Unstable
m s vs i targets when lm unstable
1. LM unstable: fluctuates from LM' to LM''

2. i target at i*: Y = Y*

3. M target: Y fluctuates from YM' to YM''

4. Y fluctuation is less with i target

Conclusion:If LM curve is more unstable than IS curve, i target is preferred

Ms vs. i Targets When LM Unstable
the islm model in the long run
Panel (a)

1. Ms, LM right to LM2, go to point 2, i to i2, Y to Y2

2. Because Y2 > Yn, P, M/P, LM back to LM1, go back to point 1

Panel (b)

1. G, IS right to IS2, go to point 2 where i = i2 and Y = Y2

2. Because Y2 > Yn, P, M/P, LM left to LM2, go to point 2', i = i2` and Y= Yn.

The ISLM Model in the Long Run