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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

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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

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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

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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

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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)

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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.

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BlCh57 Shifts of IS i Y IS GTc0I0GTc0I0 GTc0I0GTc0I0 Expansionary Contractionary

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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

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BlCh59 Construction of the LM curve i i M/P Y MsMs Y 0 Y 1 i0i0 M d (Y 0 )

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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

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BlCh511 Expansionary monetary policy: an increase in M s A i i M/P Y M d (Y 0 ) Y0Y0 i0i0 MsMs LM

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BlCh512 Shifts of LM Y i LM MsPVMsPV MsPVMsPV Expansionary Contractionary

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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

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BlCh514 The IS-LM graph i Y

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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

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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

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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

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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

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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

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BlCh520 A fiscal expansion i ieie Y YeYe LM IS A The economy moves along the LM curve from A to A’

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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’.

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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.

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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

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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

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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%

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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.

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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

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BlCh528 A monetary contraction LM IS i Y A YeYe ieie

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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 =.

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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.

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BlCh531 i M/P Y i MsMs M’ s IS LM MdMd i YeYe A monetary contraction

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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

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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.

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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:

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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:

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