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**Goods and of Financial Market : The IS-LM Model**

The Goods Market and The IS Relation Y = C (Y-T) + I + G Investment, Sales, and The Interest Rate I = I (Y, i) (+, -) Where : Y = Production i = Interest rate

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The IS Curve Y = C (Y-T) + I (Y, i) + G The supply of goods (the left side) must be equal to the demand for goods (the right side)

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**The Effects of an Increase in The Interest rate on Output**

ZZ Demand, z For interest rate, i A ZZ’ For interest rate I’>i A’ Y’ Y Output, Y

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**The Derivation of the IS Curve**

ZZ ZZ’ A A’ Y’ Y Output, Y Interest rate, i A’ i’ A i IS curve Y’ Y Output, Y

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**The Shifts in the IS Curve**

Interest rate, i i IS ( For taxes T) IS ( for T’>T) Y’ Y Output, Y

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**Financial Markets and The LM Relation**

MS = M d M = $ YL (i) Variable M on The left side is the nominal money stock M/P = Y L (i) ………….. LM Relation

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**The effects of an increase in Income on the interest rate**

M d (for Income Y) A A’ i’ i Interest rate, i M/P Real Money, M/P) M d’ (for Y’> Y)

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**The Derivation of The LM Curve**

M d’ (for Y’> Y) M d (for Income Y) A’ A M/P (Real Money, M/P) i I’ Y Y’ Interest rate, i LM Income, Y

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**Shifts in The LM Curve LM (for M/P) Interest rate, i**

Income, Y Interest rate, i i’ i Y LM (for M/P) LM ‘ (for M’/P > M/P) An Increase in Money

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**The IS-LM Model : Exercises**

IS Relation Y = C(Y-T)+I(Y, i) + G LM Relation M/P = Y L( i )

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**The IS-LM Model Interest rate, i Equilibrium in Financial Market (LM)**

Income, Y Y i Interest rate, i Equilibrium in Goods Market (IS)

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**Fiscal Policy, Activity, and The Interest Rates**

Decrease in G-T Fiscal contraction/ Fiscal Consolidation Increase in G-T Fiscal Expansion

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In answering this or any question about the effects of Changes in policy, always follow these three steps : Ask how this change affects good and financial market equilibrium relations , how its shifts the IS or/and the LM Curve Characterize the effects of these shifts on the equilibrium Describe the effects in the words

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**How The Increase in Taxes**

The Increase in taxes affects equilibrium in the goods market (IS) The increase in taxes affects decreases consumption ( because people have less disposable income ) and through the multiplier, decreases output What Happens to the LM Curve ? nothing

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**The effects of an Increase in Taxes**

IS (for T) IS’ (for T’> T) Output, Y Interest rate, i i’ i LM Y’ Y An Increase in taxes shifts the IS curve to the left, and leads to a decrease in equilibrium output and the equilibrium interest rate

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**Monetary Contraction/ Monetary Tightening**

Monetary Policy, Activity, and The Interest Rates Increase in Money (M) Monetary expansion Decrease in Money (M) Monetary Contraction/ Monetary Tightening

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**How The Central Bank Increases Nominal Money, through open market operation (Price level is fixed)**

The Increase in Nominal money affects equilibrium in the Financial market (LM) An increase in money shifts the LM down What Happens to the IS Curve ? Nothing 18

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**The effects of a monetary Expansion**

IS LM (for M/P) LM’ (for M’/P) > M/P) Interest rate, i Output, Y Y Y’ i I’ A monetary expansion leads to higher output and a lower interest rate

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**The Effects of Fiscal and Monetary Policy**

Shifts in IS Shifts in LM Movement in Output Movement in Interest Rate Increase in Taxes Left None down Decrease in taxes Right Up Increase in Spending Decrease in Spending Increase in money Decrease in money

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Using a Policy Mix Some times monetary and fiscal policies is used to offset the adverse on the demand for goods of fiscal contraction Some times the monetary-fiscal mix emerges from tensions or even disagreements between the government (which is in charge of fiscal policy) and the central bank (which is in charge of monetary policy)

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**Table : Selected Macro Variables for USA, 1991-1998**

1991 1992 1993 1994 1995 1996 1997 1998 Budget Surplus (% of GDP) (minus sign : deficit) -3.3 -4.5 -3.85 -2.7 -2.4 -1.04 -0.3 0.8 GDP Growth (%) -0.9 2.7 2.3 3.4 2 3.9 3.7 Interest Rate (%) 7.3 5.5 3.3 5 5.6 5.2 4.8 Source : Bureau of economic Analysis

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**Deficit Reduction and Monetary Expansion**

Output, Y Interest rate, i IS’ IS LM LM’ A A’ B i I’ Y The Right Combination of deficit reduction and monetary expansion can achieve a reduction in the deficit without adverse effects on output

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**Adding Dynamics Source of dynamics in goods market :**

Production adjusts slowly to demand Demand (consumption and investment) adjusts slowly to income (production) Slow adjustment of Y in goods market Fast adjustment of i in financial market

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Output, Y A B YA YB iA IS’ IS Output decreases slowly Output Increases slowly LM’ LM iB Interest rate, i Goods Market Financial Market Interest rate Adjust Instantaneously Interest rate, i

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**The Dynamic effects of a Monetary contraction**

Interest rate, i IS LM’ LM A A’ A’’ i’ i’’ i Y Y’ A monetary contraction leads To an increase in the interest Rate. The Increase in the Interest rate leads, over time To decline in output Output, Y

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**Monetary and Fiscal Policy : an Example**

Consider the following IS-LM Model : C = YD I = Y – 1000 I G = 250 T = 200 (M/P) d = 2Y i M/P = 1,600

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**Derive the equation for the IS curve**

Derive the equation for LM curve Solve for equilibrium real output Solve equilibrium interest rate Solve for equilibrium values of C and I Now Suppose that the money supply increases to M/P = Solve Y, i, C and explain in words the effects of expansionary monetary policy Set M/P equal its initial value of 1600, Now suppose that government spending increase to G = 400. Summarize the effects of expansionary fiscal policy on Y, i and C. and why if government spending decrease to G = 100

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1 of 59 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall CHAPTER OUTLINE 11 Aggregate Demand in the.

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