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IS - LM Model By Wong Chuen-Ping

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2 markets Goods Market Equilibrium: E = Y C + I = C + S I = S Money Market Equilibrium: Md = Ms

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S = 0.2Y - 40 I = 260 - 2000r In equilibrium : S = I 0.2Y - 40 = 260 - 2000r Y = 1500 - 10000r The Goods Market 1500 YSIr 60 0.10 700100 0.08 900140 1100180 0.04 1300220 0.02 260 0 500 0.06 IS equation

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The Goods Market Y = 1500 - 10000r

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IS curve IS curve shows all the combinations of real national income (Y) and real interest rate (r) at which the goods market is in equilibrium.

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How to derive IS curve? r Y S I 45 0 IS I r1r1 S r2r2 I2I2 I1I1 S1S1 S2S2 Y1Y1 Y2Y2

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ED & ES in product market r Y IS I=S E=Y A(Y, S )C (Y. S ) B S>I Y>E ES S*
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Disequilibrium in product market r Y IS ED ES I>S E>Y I~~
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rr I I Y Y SS 45 I S r1r1 I1I1 S1S1 Y1Y1 IS r2r2 Y2Y2 I2I2 S2S2 The IS Curve

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IS Curve S, I YY r Y1Y1 Y2Y2 I1I1 S Y1Y1 I2I2 Y2Y2 r1r1 r2r2 IS at r 1, investment = I 1 at r 2, investment = I 2 Lower r, higher I

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Ms =400 Mt = 0.25Y Ma = 250 – 2000r In equilibrium : Ms = Mt + Ma 400 = 0.25Y + 250 - 2000r Y = 600 + 8000r The Money Market 0.125 600 0.05 LM equation YMsMtMar 4001502500 1000400250150 1600400 0

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The Money Market Y = 600 + 8000r YR 6000 100005 14000.1

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LM curve LM curve shows all the combinations of real national income (Y) and real interest rate (r) at which the money market is in equilibrium.

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How to derive LM curve? r Y Mt Ma LM Ma r1r1 Mt r2r2 A2A2 A1A1 T1T1 T2T2 Y1Y1 Y2Y2 K O H Ms=OH=OK

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ED & ES in Money market r Y LM Md=Ms A(Y, Mt )C (Y. Mt ) B Md>Ms ES Md

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Disequilibrium in Money market r Y LM ED ES Md>Ms Md

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rr Ma Y Y Mt Ma Mt r1r1 A1A1 T1T1 Y1Y1 LM r2r2 Y2Y2 A2A2 T2T2 The LM Curve O H K Ms=OH=OK

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LM Curve r MY r Md 1 Ms Y1Y1 Md 2 Y2Y2 r1r1 r2r2 LM at Y 1, Md = Md1 at Y 2, Md = Md 2 Higher Y, higher Md r1r1 r2r2

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Equilibrium in Product & Money Market r LM IS YY1 r1 A

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Disquilibrium in Product & Money Market r LM IS Y F G H J Ms Md > > < < I S > > < <

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IS-LM Equations Goods Market C = 100 + 0.8Y I = 200 - 400r In equilibrium: Y = E = C + I IS equation: Y = 1500 - 2000r Money Market Ms = 300 Mt = 0.2Y Ma = 50 - 100r In equilibrium: Ms = Md =Mt + Ma LM equation: Y = 1250 + 500r R = 0.1 i.e. 10% Y = 1300

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IS-LM Equations Goods Market C = 100 + 0.75Yd I = 300 - 7000r G = 525 T = 20%(Y-100) IS equation ? Money Market Ms = 800 Mt = 120 + 0.4Y Ma = 240 - 3000r LM equation ? r = 0.05 i.e. 5% Y = 1475 Y = 2350 - 17500r Y = 1100 + 7500r

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Shifts in the IS curve r Y S I 45 0 IS1 I1 r1r1 S r2r2 I2I2 I1I1 S1S1 S2S2 Y1Y1 Y2Y2 I2 IS2 I

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Increase in Investment ( or↑G) r IS 1 YY1Y1 r1 A IS 2 Y2Y2 ↑I, at same r, Y↑, △ Y = △ I x B IS shifts to the right

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Shifts in the IS curve r Y S I 45 0 IS 1 I1I1 r1r1 S1S1 I1I1 S1S1 Y1Y1 Y2Y2 IS 2 S2S2 S

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Decrease in Saving ( or ↓ T) r IS 1 YY1 r1 A IS 2 Y2 ↓ S, at same r, E ↑, Y ↑, B IS shifts to the right

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Shifts in the LM curve r Y Mt Ma LM1 Ma r1r1 Mt A1A1 T1T1 Y1Y1 Ms LM2

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Increase in Money Supply r LM 1 YY1 r1 A LM 2 B at same Y, ↑Ms, Ms > Md, r ↓ LM shifts to the right

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Increase in Money Supply r LM 1 YY1Y1 r1 A LM 2 B Y2Y2 ↑Ms, at same r, Y↑, LM shifts to the right △ Y = △ Ms x

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Shifts in the LM curve r Y Mt Ma LM1 Ma r1r1 Mt 1 A1A1 T1T1 Y1Y1 O Mt LM2 Mt 2

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Decrease in Mt r LM 1 YY1 r1 A LM 2 B at same Y, Mt ↓, Ms > Md, r ↓ LM shifts to the right

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Shifts in the LM curve r Y Mt Ma LM1 Ma1 r1r1 Mt 1 A1A1 T1T1 Y1Y1 O LM2 Ma 2 Ma

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Increase in Ma r LM 1 YY1 r1 A LM 2 B at same Y, Ma↑, Ms < Md, r↑ LM shifts to the left

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Increase in Investment (↑G, ↑C) r LM IS 1 YY1 r1 A IS 2 B r2 Y2

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Increase in Saving (↑Tax) r LM IS 1 YY1 r1 A IS 2 B r2 Y2

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Increase in Money Supply (↓Md) r LM 1 IS YY1Y1 r1 A LM 2 B r2r2 Y2Y2

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Increase in demand for Money (↓Ms) r LM 1 IS YY1Y1 r1 A LM 2 B r2r2 Y2Y2

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Slope of the IS curve & MPS Smaller MPS, greater multiplier, flatter IS r ↓, I ↑→↑Y Y Y1 r1 Y2 r2 r IS 1 IS 2 larger MPS, steeper IS Smaller MPS, flatter IS Y3 (ΔY = ΔI x )

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Slope of IS & Interest elasticity of I more interest elastic investment, flatter IS r ↓, I ↑, Y Y1 r1 Y2 r2 r IS 1 IS 2 Less interest elastic I, steeper IS Y3 flatter IS more interest elastic, larger ΔI, largerΔY More interest elastic I,

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Slope of LM & Income elasticity of Mt more income elastic Mt, steeper LM Y ↑, Mt ↑, Y Y1 r1 Y2 r LM 1 LM 2 more income elastic Mt, steeper LM Less income elastic Mt, flatter LM more income elastic Mt, larger ↑in Mt, largerΔr

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Slope of LM & Interest elasticity of Ma less interest elastic Ma, steeper LM Y ↑, Mt ↑, Y Y1 r1 Y2 r LM 1 LM 2 less interest elastic Ma, steeper LM more interest elastic Ma, flatter LM Md > Ms, r↑to ↓Ma, less r elastic Ma, largerΔr

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Fiscal Policy - ↑G r LM IS 1 YY1 r1 A IS 2 B r2 Y2 F AF =ΔG x Crowding-out effect

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The crowding-out effect refers to the reduction in income resulting from an increase in interest rate. G E E >Y Y Mt Md > Ms r r I Y (crowding-out effect) The crowding-out effect

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r LM IS 1 YY1 r1 A IS 2 B r2 Y2 F AF =ΔG x Crowding-out effect

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condition of employment (unemployment, ? crowding-out effect) (full employment, ? Crowding-out effect) interest elasticity of demand for money, more interest elastic, smaller change in r, crowding-out effect ?. interest elasticity of investment, less interest elastic, when r , smaller in I, crowding-out effect ?. Factors affecting the crowding-out effect smaller larger smaller

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Fiscal Policy - ↑Tax r LM IS 1 YY1 r1 A IS 2 B r2 Y2 r LM IS 1 YY1 r1 A IS 2 B r2 Y2 Lump sum tax ↑, IS shifts left Tax rate ↑, IS steeper

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Fiscal Policy - Equal↑in G & T r LM IS 1 YY1 r1 A IS 2 B r2 Y2 F AF =ΔG = ΔT Crowding-out effect

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Monetary Policy - ↑Ms r LM 1 IS YY1Y1 r1 A LM 2 B r2r2 Y2Y2

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Fiscal & Monetary Policies - ↑Ms + ↑G r LM 1 IS1 YY1 r1 A LM 2 B Y2 IS2

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Effectiveness of Monetary Policy & slope of IS r LM 1 IS 1 YY0Y0 r0 A LM 2 r1r1 Y1Y1 IS 2 Y2Y2 r2r2 C Ms ↑→r↓→I↑, LM →right, Monetary Policy is more effective if IS is flatter B more interest elastic (flatter IS), larger ↑I, larger↑Y smaller MPS (flatter Y), larger ↑Y

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Effectiveness of Fiscal Policy & slope of LM r LM1 IS 1 YY1 r1 A IS 2 B r2 Y2 Crowding-out effect LM2 C r3 Y3 Fiscal Policy is more effective if LM is flatter G ↑, IS →right, Y ↑ → Mt↑, Mt less income elastic, Ma more interest elastic, r ↑smaller, crowding-out smaller

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r r Ma Y Y Mt Ma Mt r1r1 T1T1 Y1Y1 LM The LM Curve with liquidity trap O H K Ma – perfectly interest elastic Horizontal LM Y2Y2

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r r Ma Y Y Mt Ma Mt r1r1 Y1Y1 LM The LM Curve with Ma perfectly interest inelastic O H K Ma – perfectly interest inelastic r2r2 vertical LM

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rr I I Y Y SS 45 I S r1r1 I1I1 S1S1 Y1Y1 IS r2r2 The IS Curve with perfectly interest inelastic I Investment perfectly interest elastic IS vertical

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Horizontal LM r LM IS 1 YY1 r1 A IS 2 B Y2 r LM IS 1 YY1 r1 A Fiscal Policy effective Monetary Policy ineffective G↑G↑ Ms ↑

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Vertical LM rLM IS 1 YY1 r1 A IS 2 B r LM 1 IS 1 YY1 r1 A Fiscal Policy ineffective Monetary Policy effective r2 G↑G↑ Ms ↑ LM 2 r2 Y2 B

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Vertical IS r LM IS 1 YY1 r1 A IS 2 B r LM 1 IS YY1 r1 A Fiscal Policy effective Monetary Policy ineffective r2 G↑G↑ Ms ↑ LM 2 r2 B Y2

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Horizontal IS r IS LM YY1 r1 A r LM 1 IS Y Y1 r1 A Fiscal Policy ineffective Monetary Policy effective G↑G↑ Ms ↑ LM 2 B Y2

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