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 Y and the equilibrium i in the economy in the short run (with fixed prices) The goods market will be represented by the IS curve (standing for investment-savings) The financial markets (money market) will be represented by the LM curve (liquidity- money) 1. The Hicks-Hansen model based on Keynes’ General Theory

BlCh52 The goods market - IS curve Equilibrium condition Y = Z  C + I + G Investment will provide the link to the financial markets Determinants of investment: –If sales increase, producers might want to increase their productive capacity Y –If the rate of interest rate i increases, producers find that borrowing to add new capital becomes more expensive

BlCh53 Equilibrium in the goods market becomes: Y = C(Y-T)+I(Y,i) + G Basically –When i I and Y e The ZZ curve shifts 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 MPC + MPI and the interest rate is included in the intercept

BlCh54 Construction of the IS curve Z Y Y i IS Y’ e YeYe YeYe Y=Z ZZ(i) ZZ’(i’) 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. E E’ i

BlCh55 The IS curve Y = C(Y-T)+I(Y, i) + G Definition: All the combinations of i and Y such that the goods market is in equilibrium i.e. the above equation is satisfied Shift of the IS: A change in any of the exogenous variables in the equation will cause IS to shift. –Shift variables: c 0 and I 0 (confidence variables) T and G (policy - fiscal - variables)

BlCh56 Expansionary fiscal policy: increase in G Z Y Y i IS’ YeYe Y’ e YeYe Y=Z ZZ’(G+∆G) ZZ (G) i E’ ∆G E IS When G increases, ZZ shifts up and IS shifts to the right. An increase in T would has the opposite effect as it is contractionary.

BlCh57 Shifts of IS i Y IS GTc0I0GTc0I0 GTc0I0GTc0I0

BlCh58 The financial markets - LM curve Equilibrium condition 1 : supply of money = demand for money M s = PYL(i) or M s /P = YL(i) (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

BlCh59 Construction of the LM curve E E’ i i M/P Y LM MsMs M’ d (Y 1 >Y 0 ) M d (Y 0 ) Y 0 Y 1 i0i0 i1i1

BlCh510 The LM curve M s = PYL(i) Definition: All the combinations of i and Y such that the financial markets (bonds and money) are in equilibrium Shift of the LM curve: a change in the money supply or a change in price or an exogenous shift in the money demand –An increase in the money supply ( or a decrease in price) is expansionary –A change in the velocity of money

BlCh511 Expansionary monetary policy: an increase in M s A A’ i i M/P Y LM’ M’ s M d (Y 0 ) Y 0 Y 1 i1i1 i0i0 MsMs LM

BlCh512 Shifts of LM Y i LM MsPVMsPV MsPVMsPV Expansionary Contractionary