Presentation on theme: "BlCh51 Goods and Financial Markets 1 : IS-LM Goal: link the goods and the financial markets into a more general model that will determine the equilibrium."— Presentation transcript:
BlCh51 Goods and Financial Markets 1 : IS-LM Goal: link the goods and the financial markets into a more general model that will determine the equilibrium and the equilibrium in the economy (with prices) The goods market will be represented by the curve (standing for investment-savings) The financial markets (money market) will be represented by the curve (liquidity- money) 1. The Hicks-Hansen model based on Keynes’ General Theory
BlCh52 The goods market - IS curve Equilibrium condition will provide the link to the financial markets Determinants of investment: –If increase, producers might want to increase their productive capacity by investing in capital goods. –If, producers find that borrowing to add new capital becomes more expensive
BlCh53 Equilibrium in the goods market becomes: Y = Basically –When i I and Y e The ZZ curve shifts now as the interest rate changes and a multiplier effect takes place –If MPI is the marginal propensity to invest out of new income, assume that MPC + MPI < 1 –The slope of the ZZ curve is now and the interest rate is included in the intercept
BlCh54 Construction of the IS curve Z Y Y i Y’ e YeYe YeYe i i’ When the interest rate increases, I (Y, i) drops and the ZZ curve shifts down. The economy contracts from Y e to Y’ e. E and E’ correspond to 2 combinations of i and Y, such that the good market is in equilibrium. i
BlCh55 The IS curve Y = Definition: All the combinations i.e. the above equation is satisfied Shift of the IS: A change in any of the in the equation will cause IS to shift. –Shift variables: (confidence variables) (fiscal policy variables)
BlCh56 Expansionary fiscal policy: increase in G Z Y Y i YeYe YeYe Y=Z ZZ (G) i E IS When G increases by ∆G, ZZ shifts up and IS shifts to the right. An increase in T would has the opposite effect as it is contractionary.
BlCh57 Shifts of IS i Y IS GTc0I0GTc0I0 GTc0I0GTc0I0 Expansionary Contractionary
BlCh58 The financial markets - LM curve Equilibrium condition 1 : supply of money = demand for money M s = or M s /P = (M s /P is the real money supply) It is clear that both LM and IS are relations between i and Y 1. The bonds market is automatically in equilibrium when the money market is in equilibrium
BlCh59 Construction of the LM curve i i M/P Y MsMs Y 0 Y 1 i0i0 M d (Y 0 )
BlCh510 The LM curve M s = Definition: All the combinations of and such that the ( and ) are in equilibrium Shift of the LM curve: a change in the money or a change in or an exogenous shift in the money demand –An in the money supply ( or a in price) is expansionary –A change in the velocity of money
BlCh511 Expansionary monetary policy: an increase in M s A i i M/P Y M d (Y 0 ) Y0Y0 i0i0 MsMs LM
BlCh512 Shifts of LM Y i LM MsPVMsPV MsPVMsPV Expansionary Contractionary
BlCh513 The IS-LM model Y = IS curve M/P = LM curve IS is sloped and LM is sloped, they will intercept in E determining Y and i in equilibrium. At that point, all three markets : two financial markets and the goods market, are
BlCh514 The IS-LM graph i Y
BlCh515 Problem # 4 IS-LM model: C = Y D I = Y i G = 250 and T = 200 (M/P) d = 2Y i M/P = 1,600 IS LM
BlCh516 a.Derive the IS curve: Y = C + I + G Y = Y-.25T Y i = Y i Y -.5Y = i Y (1 -.5) = i Y = [1/.5] ( i)multiplier = 2 IS curve:Y = i
BlCh517 b.Derive the LM curve: YL(i) = M/P 2Y i = i = 2Y LM curve: i = Y/ c. Solve IS-LM for equilibrium Y Y = i = (Y/ ) = Y Y = 1500so Y = 1000
BlCh518 d.i = Y/ = 1000/ = =.05 so i = 5% e.Replace equilibrium Y and i into C and I C = * *200 = 400 I = * *.05 = 350 G = 250 So Y = = 1000
BlCh519 Fiscal Policy Instruments: Curve affected: Effect: Expansionary: when (G-T) or G or T IS shifts to the Contractionary: when (G-T) or G or T IS shifts to the
BlCh520 A fiscal expansion i ieie Y YeYe LM IS A The economy moves along the LM curve from A to A’
BlCh521 Mechanics of fiscal expansion Goods market effects As G Y = too immediately Then C= and I = also Multiplier effect: at same i, Y reaches a higher level as IS shifts to the right Financial markets effects As Y the demand for money M = and the ward shift in M d results in a i, but this is a movement along the curve to A’.
BlCh522 Effect on investment As i increases, investment is. So there are 2 opposite effects on investment as Y increases I as i increases I It means that the overall expansion due to the increase in G will be by the impact of the increase in the interest rate on investment. There is some of private investment due to the increase in government spending.
BlCh523 Z Y Y i YeYe Y” YeYe Y=Z ZZ (G) i ∆G IS LM i M/P MsMs MdMd i i’ Y’ e i’ Expansionary Fiscal Policy
BlCh524 Net effect of increase in G on investment 1. Using investmt funct as Y increases I as i increases I Net effect is ambiguous 2. Using equil condition as Y increasesS p as G increases(T - G) Net effect is ambiguous
BlCh525 Problem # 5 cont. g.A fiscal expansion: G increases to 400 New IS curve: Y = Y i Y = [1/.5] ( i) = i Same LM curve: i = Y/ Solve: Y = (Y/ ) 1.5Y = 1800 so Y = 1200 Replace in LM and we get i =.10 or 10%
BlCh526 Calculate the corresponding equilibrium for C & I C = Y -.25T = = 450 I = Y i = = 350 Y = C + I + G = = 1200 Impact of fiscal expansion: both Y and i increase. C (a function of Y) increases too. I increases when Y increases and decreases when i increases (ambiguous results overall). With these data, I does not change as the two effects neutralize each other.
BlCh527 Monetary policy Instrument: Curve affected: Effect: Expansionary when M s increases LM shifts to the Contractionary when M s is cut LM shifts to the
BlCh528 A monetary contraction LM IS i Y A YeYe ieie
BlCh529 Mechanics of a monetary contraction Open market of bonds Suppose P=1 constant - so monetary contraction in terms is equivalent to a terms one. Financial market effects As M s drops, i - money market effect. Goods market effects As i increases, investment I = I(Y,i) is affected and Y =.
BlCh530 Effect on investment Unambiguous: as Y drops and i increases, investment can only. Note that the money demand will shift to the left as Y drops dampening the extent of the increase in the interest rate on the fall of I and subsequently on the fall of Y.
BlCh531 i M/P Y i MsMs M’ s IS LM MdMd i YeYe A monetary contraction
BlCh532 Problem #5 cont. g. Monetary expansion: M/P increases to 1840 Same IS curve: Y = i New LM curve: 2Y i = 1840 i = Y/ /8000 i = Y/ Solve the IS-LM system: Y = (Y/ ) Y = Y Y = 1560 so Y = 1040
BlCh533 Replace in LM: i = 1040/ so i =.03 or 3% Solve for C and I C = 410 and I = 380 A monetary expansion reduces i and increases Y Thus C (function of Y) increases and I (function of Y and of i) increases unambiguously.
BlCh534 Policy Mix 1 To maximize the expansionary (or contractionary) impact on the economy, use both expansionary monetary and expansionary fiscal policy (or both contractionary). i Y IS LM Rational:
BlCh535 To dampen the inflationary impact of an expansionary fiscal policy, use at the same time contractionary monetary policy. i Y IS LM Policy Mix 2 Rational: