The Goods Market and the IS Curve How fiscal policy shifts the IS Curve: In summary: Expansionary Fiscal Policy (increase in Government Purchases or decrease in taxes) will shift the IS Curve to the right Contractionary Fiscal Policy (decrease in Government Purchases or increase in taxes) will shift the IS Curve to the left Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Money Market and the LM Curve Summary so far: We are using the IS-LM model to derive the aggregate demand curve to study economic fluctuations in the economy in the short run IS-LM model is an interpretation of John Maynard Keyne’s theory on aggregate demand We have derived the IS Curve using the Keynesian Cross and the Investment Function Now we need to derive the LM Curve Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Money Market and the LM Curve The LM Curve plots the relationship between the interest rate and the level of income that arises in the money market We use the Theory of Liquidity Preference to derive the LM Curve Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Money Market and the LM Curve Theory of Liquidity Preference: Keynes’s theory: the interest rate adjusts to balance the supply and demand of money in the short run Begin with the supply of real money balances M = supply of money P = price level (M/P)s = supply of real money balance Note: real money balance means the quantity of money expressed in terms of the quantity of goods and services it can buy Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Money Market and the LM Curve Theory of Liquidity Preference: This theory assumes that the supply of real money balances is fixed Therefore: (M/P)s = M/P M (Money supply) is fixed because it is chosen by the central bank – it’s an exogenous variable P (price level) is fixed because this is a model of the short run and prices are sticky or fixed in the short run Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Money Market and the LM Curve Theory of Liquidity Preference: Therefore, the supply of real money balances is fixed and does not depend on the interest rate In a graph, the supply of real money balances is a vertical line See graph (next slide) Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Money Market and the LM Curve Interest rate, r Supply M/P Real Money Balances, M/P Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Money Market and the LM Curve Theory of Liquidity Preference: Next consider the demand for real money balances The interest rate is one determinant of how much money (cash) people to choose to hold Interest rate is the opportunity cost of holding money (cash in your pocket) Because if you weren’t holding money as cash you would put it in a bank deposit account that would earn interest Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Money Market and the LM Curve Theory of Liquidity Preference Demand for real money balances: when the interest rate rises people want to hold less money (cash) (thus demand less cash) and instead invest it in a bank etc. to earn the high interest rate Therefore: (M/P)d = L(r) The demand for real money balances is a function of interest rates (Note: L stands for liquidity but just means a ‘function of’) Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Money Market and the LM Curve Theory of Liquidity Preference: In a graph the demand for real money balances is downward sloping because it depends negatively on the interest rate See graph on next slide (curve drawn during lecture) Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Money Market and the LM Curve Interest rate, r M/P Real Money Balances, M/P Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Money Market and the LM Curve Theory of Liquidity Preference The combination of the supply and demand for real money balances shows the equilibrium interest rate According to the theory of liquidity preference, the interest rate adjusts to equilibriate the money market See graph on next slide Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Money Market and the LM Curve Theory of Liquidity Preference Why does the interest rate adjust to equilibriate the money market? For example, if the interest rate is above the equilibrium level, quantity of real money supplied exceeds the quantity demanded People holding the excess supply of money want to earn the high interest rate and deposit it in a bank account Banks respond to this by lowering their interest rates (they prefer to pay lower interest rates on the deposit accounts) And the interest falls until equilibrium is reached Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Money Market and the LM Curve Theory of Liquidity Preference: Now, suppose the central bank decreases the money supply (M/P)s: M falls and P is fixed in the model Therefore (M/P)s falls and the supply of real money balances line shifts to the left and the interest rate rises from r1 to r2 See graph on next slide Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Money Market and the LM Curve Using this theory of liquidity preference, we can now drive the LM Curve The LM Curve plots the relationship between interest rates and income that arises in the money market So we need to see how income affects the money market A change in income will affect the demand for real money (recall this from chapter on Money and Inflation) Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Money Market and the LM Curve Deriving the LM Curve: When income is high, expenditure is high, so people engage in more transactions that requires the use of money (cash) The greater income, the greater the money demand Therefore, money demand function can be written as: (M/P)d = L(r, Y) Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Money Market and the LM Curve Deriving the LM Curve: The quantity of real money demand is negatively related to interest rates and positively related to income If there is an increase in income, this will cause the money demand curve to shift upwards or to the right (it’s a shift of the curve because income is not on either axis (interest rates and real money balances are on the axes)). This shift of the demand curve then will result in an increase in the interest rates See graph (a) on next slide Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Money Market and the LM Curve Deriving the LM Curve: Therefore, according to the Theory of Liquidity Preference, an increase in income results in a higher demand for real money and thus leads to a higher interest rate The LM curve summarises this relationship We start off at income Y1. At this income level real money demand equates with real money supply at interest rate r1 Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Money Market and the LM Curve Deriving the LM Curve: At income Y1, interest rate is r1 Plot this as one point showing the relationship between interest rates and income in the money market Then, income rises to Y2, this causes an increase in money demand, so money demand curve shifts to the right and this leads to a higher interest rate, r2 Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Money Market and the LM Curve Deriving the LM Curve: At income Y2, interest rate is r2 Plot this as another point showing the relationship between interest rates and income in the money market Join the dots and you get an upward sloping LM curve See graph (b) on previous slide with graphs Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10