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**Goods and Financial Markets1: 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 BlCh5

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**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 BlCh5

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**Equilibrium in the goods market becomes: Y = Basically**

When i I and Ye When i I and Ye 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 BlCh5

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**Construction of the IS curve**

Z When the interest rate increases, I (Y, i) drops and the ZZ curve shifts down. The economy contracts from Ye to Y’e. E and E’ correspond to 2 combinations of i and Y, such that the good market is in equilibrium. i Y Y’e Ye i i’ i Y Y’e Ye BlCh5

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**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) BlCh5

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**Expansionary fiscal policy: increase in G**

Y=Z Z ZZ (G) 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. Y Ye i E i IS Y Ye BlCh5

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**Shifts of IS Expansionary Contractionary i G T c0 G I0 T c0 I0 IS Y**

BlCh5

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**The financial markets - LM curve**

Equilibrium condition1: supply of money = demand for money Ms = or Ms/P = (Ms/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 BlCh5

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**Construction of the LM curve**

Ms i i i0 Md(Y0) M/P Y Y1 Y BlCh5

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The LM curve Ms = 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 BlCh5

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**Expansionary monetary policy: an increase in Ms**

LM i A i0 Md(Y0) M/P Y0 Y BlCh5

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Shifts of LM Contractionary i LM Ms P V Ms P V Expansionary Y BlCh5

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**sloped, they will intercept in E determining Y and i in equilibrium. **

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 BlCh5

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The IS-LM graph i Y BlCh5

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**Problem # 4 IS-LM model: C = 200+ .25YD I = 150 + .25Y - 1000i**

G = 250 and T = 200 (M/P)d = 2Y i M/P = 1,600 IS LM BlCh5

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**Derive the IS curve: Y = C + I + G **

Y = Y- .25T Y i + 250 = Y i Y - .5Y = i Y (1 - .5) = i Y = [1/.5] ( i) multiplier = 2 IS curve: Y = i BlCh5

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**Derive the LM curve: YL(i) = M/P 2Y - 8000i = 1600 8000i = 2Y - 1600 **

LM curve: i = Y/ c. Solve IS-LM for equilibrium Y Y = i = (Y/ ) = Y + 400 1.5Y = so Y = 1000 BlCh5

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**Replace equilibrium Y and i into C and I **

i = Y/ = 1000/ = = so i = 5% Replace equilibrium Y and i into C and I C = * *200 = 400 I = * *.05 = 350 G = 250 So Y = = 1000 BlCh5

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**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 BlCh5

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**A fiscal expansion The economy moves along the LM curve from A to A’ i**

ie A IS Ye Y BlCh5

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**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 Md results in a i, but this is a movement along the curve to A’. BlCh5

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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. BlCh5

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**Expansionary Fiscal Policy**

Y=Z Z ZZ (G) ∆G Y Ye Y” i Ms i LM i’ i’ i i IS Md M/P Y Ye Y’e BlCh5

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**Net effect of increase in G on investment**

Using investmt funct as Y increases I as i increases I Net effect is ambiguous Using equil condition as Y increases Sp as G increases (T - G) BlCh5

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**A fiscal expansion: G increases to 400 **

Problem # 5 cont. 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 = so Y = 1200 Replace in LM and we get i = .10 or 10% BlCh5

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**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. BlCh5

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**Monetary policy Instrument: Curve affected: Effect: LM shifts to the**

Expansionary when Ms increases LM shifts to the Contractionary when Ms is cut BlCh5

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**A monetary contraction**

LM ie A IS Y Ye BlCh5

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**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 Ms drops, i money market effect. Goods market effects As i increases, investment I = I(Y,i) is affected and Y = BlCh5

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**Unambiguous: as Y drops and i increases, investment can only . **

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. BlCh5

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**A monetary contraction**

M’s i Ms i IS LM i Md Ye Y M/P BlCh5

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**g. Monetary expansion: M/P increases to 1840 **

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 - 460 1.5 Y = so Y = 1040 BlCh5

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**A monetary expansion reduces i and increases Y **

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. BlCh5

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Policy Mix 1 To maximize the expansionary (or contractionary) impact on the economy, use both expansionary monetary and expansionary fiscal policy (or both contractionary). LM i IS Y Rational: BlCh5

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Policy Mix 2 To dampen the inflationary impact of an expansionary fiscal policy, use at the same time contractionary monetary policy. i LM IS Y Rational: BlCh5

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