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CHAPTER 14 IS-LM Frame work & Equilibrium

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Chapter Outline The IS-LM framework & equilibrium Development of the IS curve (from ch. 12 pg 140-144) Development of the LM curve (from ch. 13 pg. 177-180 Shifts in the IS curve Changes in real spending Changes in govt. spending Changes in the taxes Other Variables Equilibrium in money markets

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Chapter Outline cont. Shifts in the LM curve Changes in monetary policy Fiscal and monetary policy Automatic stabilizers Discretionary fiscal policy ‘Crowding out’ effect

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Development of the IS curve IS curve shows alternative combinations of the real interest rate (r) and real income (Y) such that the market for goods & services is in equilibrium The IS curve is downward sloping r IS Y

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Deriving the IS curve Interest-related expenditure function (IRE) At an interest rate of r 1 -5%, IRE is at e 1 -80 mil. When rate of interest drops to r 2 -4%, IRE increases to e 2 - 100 mil. IRE = Interest-sensitive consumption and investment spending IRE e1e1 e2e2 r r2r2 A B r1r1

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Deriving…. The effect of the increase in IRE resulting from a lower r can be shown as an increase in aggregate expenditures (e) In rate of interest In IRE (earlier graph) In Aggregate Expenditures (shifting e 1 to e 2 ) In income level IS curve is shown in Panel (2) which relates real interest rate and real income combinations reflecting equilibrium points in panel (1) – A and B (2) e1e1 B Y Y r1r1 Y2Y2 Y1Y1 Y2Y2 Y1Y1 r2r2 r A e2e2 e1e1 Y IS (1)A B Y

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Effect of an increase in G If G increases Aggregate expenditures curve shifts from e 1 to e 2 Income level increases from Y 1 to Y 2 Rate of interest does not change Thus, IS curve shifts to the right (IS 1 to IS 2 ) Interest rate remains fixed at r 1 Y e2e2 e1e1 Y A B Y2Y2 Y1Y1 Y1Y1 Y2Y2 r1r1 r IS 1 IS 2 A

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Development of the LM curve LM (Liquidity-money) curve shows alternative combinations of the interest rate and real income such that the money market is in equilibrium r o Y LM

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Deriving LM curve Money market is in equilibrium at Point A with interest rate r1 Now suppose that income increases. This will shift the demand curve for money from D 1 to D 2. D 1 corresponds to income level Y 1 and D 2 corresponds to Y 2 Interest rate goes up to r 2 LM curve shows equilibrium points A and B in the money market r2r2 r r1r1 r2r2 r1r1 D2D2 D1D1 M/P 1 M/PY2Y2 Y1Y1 Y A B LMRLMS A B

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Effect of an increase in money supply In money supply by FED In interest rate to r 2 Income level remains constant at Y 1 LM 1 curve shifts to LM 2 r1r1 r2r2 r1r1 r2r2 MS 1 M/PY1Y1 Y A B LM 1 RLMS 1 A B MS 2 LM 2 RLMS 2

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Effect of an increase in Price level Draw Graph and Explain.

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Equilibrium in IS-LM framework This Equilibrium shows the level of interest rate and real income where there is simultaneous equilibrium in both money market and the market for goods and services MSMS O rere IS A r YeYe Y

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Effect of an increase in G In G Shift in IS 1, curve to IS 2 New equilibrium at point B Interest rate (r 1 to r2 ) Income level (Y 1 to Y 2 ) r2r2 r IS 1 IS 2 A B C Y1Y1 Y2Y2 Y3Y3 Y r1r1 LM

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Effect of an increase in G…. Crowding out refers to a decrease in IRE that occurs when interest rate rises due to an increase in G When government borrows funds to finance increase in G in the financial market, interest rate goes up due to an increase in demand. The difference between point C and B shows crowding out effect

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Effect of an increase in Money Supply In money supply by Fed shift in LM curve In interest rate In income level A B LM 1 LM 2 r1r1 r2r2 Y1Y1 Y2Y2 IS o

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