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IS curve The IS curve shows the relationship between interest rates generated in financial markets and the equilibrium level of income the economy gravitates toward given these rates. The IS curve is based on the Keynesian model of chapter 20

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Derivation of the IS curve Y ad,Y Y ad i=7% Y ad i=6% Y ad i=8% 6545 6605 6665

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Plotting these same points in i and Y space i 8 7 6 6545 6605 6665 IS

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The IS curve’s position The IS curve’s position is determined by the factors that determine Y ad curve’s position. Anything,other than a drop in interest rates, that would push Y ad to the left (up) will be represented by the IS curve shifting to the right. And anything, other than a rise in interest rates, that would push Y ad to the right (down) will be represented by the IS curve shifting to the left

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An increase in real wealth for example. A A B IS IS’ Y ad B

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Definition of the LM curve The LM curve shows the relationship between the equilibrium level of income the economy and interest rates financial markets gravitate toward given this level of real income. The LM curve is based on the analysis of the money market carried out in chapter 5.

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Derivation of the LM curve Hold factors that affect M D (besides real income) constant. The higher real income is, the higher the demand for money. The higher the demand for money, the higher the equilibrium rate of interest will be. The lower real income is, the lower the demand for money. The lower the demand for money, the lower the equilibrium rate of interest will be.

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The above is the basis of the LM curve. MsMs i MDMD M D” M D’ a b c

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Let’s say that points a, b and c correspond to 6000 billion dollar, a 6500 billion and a 7000 billion levels of equilibrium income.

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Putting these points together generates the LM curve a b c LM i 60006500 7000

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The LM curve’s position The LM curve’s position is determined by the factors that determine M D and M S curves’ positions. Anything, other than a drop in income, that would push M D to the left (down) will be represented by the LM curve shifting to the right. (A drop in prices or i e falling.)

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LM curve’s position (cont’d) Anything other than a rise in income that would push M D to the right (up) will be represented by the LM curve shifting to the left. (A rise in prices or an increase i e.) Anything, that would push the money supply curve to the right (left) will cause the LM to shift in the same direction.

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For example, the Fed on net buying securities from the public will increase the money supply, push the M S curve to the right and be represented by the LM curve shifting to the right as well.

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Combining IS and LM The IS curve shows the relationship between interest rates generated in financial markets and the equilibrium level of income given these rates. The LM curve shows the relationship between the level of income and the interest rates that results in financial market equilibrium

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Therefore the point at which IS and LM intersect represents equilibrium in BOTH financial markets AND in the rest of the economy and equilibrium i and Y (interest rates and real income). i LM IS Y

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A brief discussion of “methodology” Key elements of any economic model such as the ISLM model Exogenous variables. Endogenous variables. Behavioral equations and identities. Equilibrium conditions.

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Exogenous variables Exogenous variables are determined outside the model (and therefore assumed constant). If they change, we do NOT ask why, we simply assess the impact of their changing on the model’s endogenous variables.

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In the basic macromodel (the Keynesian cross of chapter 23) think of that model’s exogenous variables as guests seated around a table. mpc CCExpected profits(LT) Real wealth PkPk i I go here!

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Endogenous variables Variables we DO want to explain. Their values are determined by the model (like Y in the basic macro model). Basically the model is designed to show how the endogenous variables are influenced by the exogenous variables.

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Behavioral equations and identities. Equations that describe how variables in the model (both endogenous and exogenous) fit together. For example, the consumption function of chapter 20 is an example of a behavioral equation showing how consumer spending relates to real income, interest rates, real wealth, and consumer confidence. The equation Y ad = C+I is an example of an identity, an equation that is true by definition.

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Equilibrium conditions Relationships that results once things have settled down. In ISLM you have two such relationships: (1) Y=Y ad Equilibrium in the “goods” market. (2) M d =M s Equilibrium in the money market.

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Comparative statics Once we have defined equilibrium conditions we are ready to show endogenous variables are influenced by the exogenous variables. In the context of ISLM this means asking such important questions such as the impact of the FED targeting a lower fed funds rate on other market interest rates and the level of real income.

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Limits of models Imitating the methods of the hard sciences but “materials” we deal with are inherently different.

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Physics versus economics Physics: Many general stable relationships with reliable constants (what is assumed exogenous IS in reality constant) For example, the mass of two objects as you derive gravitational force are assumed constant and in reality ARE constant. Economics: Many relatively unstable relationships with few reliable constants. What is assumed constant in a model often is in reality anything but constant. For example, both real income and the velocity of money in the traditional quantity “theory” of money were assumed constant but in reality both are endogenous variables.

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Models in economics nonetheless incredibly useful These simplified versions of the real world allow us to see workings of more complicated real world economies. Elaborations and refinements possible. In chapter 22,for example, we can and will make the price level endogenous. Many studies of learning and what is known as the “transference” of knowledge indicate that understanding of general principles are far more valuable than a lot of specific detailed information. In short, although it takes more time and effort, really understanding something is vital. It is far more important than simply committing to memory the “right answers”.

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Economists should strive for what Aristotle called for in his Nichomedian Ethics: “Our discussion will be adequate if it has as much clearness as the subject matter admits of.”

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Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 3 Spending, Income, and Interest Rates.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 3 Spending, Income, and Interest Rates.

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