1. © 2008 Pearson Education Canada22.1 Chapter 22 The ISLM Model

2. 1. Overview: IS-LM Model Includes money and interest rates in the Keynesian framework Examines an equilibrium where aggregate output equals aggregate demand Assumes fixed price level where nominal and real quantities are the same IS curve is the relationship between equilibrium aggregate output and the interest rate in the Goods Market LM curve is the combinations of interest rates and aggregate output for which M D = M S in the Money Market © 2008 Pearson Education Canada22.2

3. 2. Goods Market: IS Curve © 2008 Pearson Education Canada22.3

4. (1) Consumption Expenditures © 2008 Pearson Education Canada22.4 Consumption is an increasing function of 1) Disposable/After-tax Income(=Y-T), and 2) Wealth (=Value of Properties, Financial Assets, and Income Possibility(Human Wealth). C = f( Y - T, W) *Current Financial Crisis has a negative Wealth Effect: Value of Wealth down and Consumption down.

5. (2) Investment Spending = Fixed investment + Inventory investment Investment is a function of (Ex-post real) Interest rates, and Expectations. I = f(i, Exp) © 2008 Pearson Education Canada22.5

6. (3) Government Expenditures Expansionary Fiscal Policy Contractionary Fiscal Policy These are up to the government’s discretion G © 2008 Pearson Education Canada22.6

7. (4) Net Exports NX = Exports – Imports Exports depend on ‘Their’ Foreign Demands, which depends on Y of foreign country ‘Our’ Competitiveness Imports depends on ‘Our Income’. Foreign Exchange Rage affects NX as well *The Current Financial Crisis originating from the U.S. has a serious impact on Canada through a decline in Exports. NX = f(Y, Y foreign), FOREX rates) © 2008 Pearson Education Canada22.7

8. (5)Equilibrium in the Goods Market: The IS Curve Interest rates and investment spending – Negative relationship Investment and National Income - Positive relationship Thus, Interest rates(i) and National Income(Y) – Negative relationship © 2008 Pearson Education Canada22.8

9. (6)Deriving the IS Curve © 2008 Pearson Education Canada22.9

10. 3. The LM Curve: Equilibrium in the Market for Money It is the combinations of (i,Y) that satisfy the equilibrium condition in the money market: Money supply = Money Demand © 2008 Pearson Education Canada22.10

11. (1) Money Supply We have learned that the money supply curve is Vertical: Government’s supply decision does not depend on interest rate- in other words, interest rate is a result of government decision, and not a factor that affects government decision. 22.11

12. (2) Money Demand Demand for money called liquidity preference M d /P depends on income (Y), interest rates (i), and Random Shocks/Diturbances (u) Positively related to income – Raises the level of transactions – Increases wealth Negatively related to interest rates © 2008 Pearson Education Canada22.12

13. (3) Equilibrium in the Market for Money: The LM Curve (Cont’d) Connects points that satisfy the equilibrium condition that M D = M S For each level of aggregate output, the LM curve tells us what the interest rate must be for equilibrium to occur The economy tends to move toward points on the LM curve © 2008 Pearson Education Canada22.13

14. (4)Deriving the LM Curve © 2008 Pearson Education Canada22.14

15. *Different Slopes of LM curves: © 2008 Pearson Education Canada22.15 1 2 3

16. *Note that the slope of LM curve is the mirror image of the Md curve: When real money demand is perfectly elastic with respect to interest rate, the corresponding LM curve is almost horizontal. This is the case of ‘Liquidity Trap’. © 2008 Pearson Education Canada22.16

17. 4. Combining IS-LM curves: Determination of Output and Interest Rate © 2008 Pearson Education Canada22.17

18. In this chapter, we simply derive IS and LM curves. In the next chapter, we will talk about the shift of IS and LM curves. © 2008 Pearson Education Canada22.18