1 IS-LM MODEL Miscellaneous

2 Simple Keynesian Model v.s. IS-LM Model G ’ (b = 0) C, I, G, G’, AD Y r Y IS 1 Slope = s/b =  b = I/r = 0 (C’-cT’+I’+G’)/s IS 2 LM

3 Simple Keynesian Model v.s. IS-LM Model G ’ (b = 0) Simple Keynesian Model Ye = k E G ’ = G ’ /s IS-LM Model Ye = k E G ’ = G ’ /s interest rate has increased but investment would not decrease since b=0, i.e., investment is perfectly interest inelastic No crowding-out effect

4 Simple Keynesian Model v.s. IS-LM Model G ’ (b  0) C, I, G, G’, I’,AD Y r Y (C’-cT’+I’+G’)/s Slope = s/b IS 1 (C’-cT’+I’+G’)/s IS 2 LM

5 Simple Keynesian Model v.s. IS-LM Model G ’ (b  0) Simple Keynesian Model Ye  k E G ’  G ’ /s IS-LM Model Shift of the IS curve: Y = k E G ’ = G ’ /s Ye  k E G ’  G ’ /s interest rate has increased and investment would decrease since b  0, the IS-LM multiplier = Ye/ G ’ = crowding-out effect 1 s+b (d/e)

6 Simple Keynesian Model v.s. IS-LM Model G ’ (e = ) C, I, G, G’, AD Y r Y (C’-cT’+I’+G’)/s Slope = d/e = 0 e = Ma/r =  Liquidity Trap d = Mt/Y = 0 LM IS 1 IS 2

7 Simple Keynesian Model v.s. IS-LM Model G ’ (e =  ) Simple Keynesian Model Ye = k E G ’ = G ’ /s IS-LM Model Ye = k E G ’ = G ’ /s Mt has increased when Y, normally, interest rate has to increase to induce people to hold less Ma, as r would raise the return from holding bond However, when there ’ s a liquidity trap, people ’ s demand for money as an asset, which provides liquidity, is unlimited (e = Ma/r = ), they would hold as much Ma as possible, r would remain constant, thus no crowding-out effect.

8 Simple Keynesian Model v.s. IS-LM Model G ’ (d = 0 ) The diagram is the same as slide no.6 Simple Keynesian Model Ye = k E G ’ = G ’ /s IS-LM Model Ye = k E G ’ = G ’ /s When there ’ s an increase in government expenditure, income increase by k E G ’, but transaction demand for money would not increase (d = Mt/Y = 0), Ma need not decrease and r need not increase. With the same interest rate, there ’ s no crowding-out effect.

9 Simple Keynesian Model v.s. IS-LM Model G ’ (Vertical LM) C, I, G, G’, I’,AD Y r Y (C’-cT’+I’+G’)/s Slope = d/e =  d=Mt/Y= e=Ma/r=0 IS 1 (C’-cT’+I’+G’)/s IS 2 LM

10 Simple Keynesian Model v.s. IS-LM Model G ’ (Vertical LM) Simple Keynesian Model Ye = 0 IS-LM Model Ye = 0 Full Crowding Out Effect When d=Mt/Y=, G’ Y by k E G’ Mt by  so Y has to reduce to the original level When e=Ma/r=0, G’ Y by k E G’ Mt but Ma would not decrease, so Mt has to reduce to the original level to restore equilibrium in the money market

11 Simple Keynesian Model v.s. IS-LM Model G ’ = T ’ (b = 0) Balanced-Budget Change C, I, G, G’, T’, AD Y r Y IS 1 Slope = s/b =  b = I/r = 0 (C’-cT’+I’+G’)/s IS 2 LM IS 3

12 Simple Keynesian Model v.s. IS-LM Model Simple Keynesian Model Cannot be used to analyze monetary policy IS-LM Model Can be used to analyze monetary policy

13 Demand Curve P Qd Slope of tangent = P/Qd = 0 Ed = (Qd/Qd)/(P/P) =  It measures the responsiveness of Qd of a good to a change in the price of the good Ed = slope of ray / slope of tangent

14 Deriving the IS Function Two-Sector Injection = Withdrawal I = S r Y S I I= I’ - br y-intercept =I’/b x-intercept = I’ slope =1/b b = I/r J = W I = S C’ = 0 = S’ S = sY slope = s s =S/Y * * IS y-intercept = I’/b x-intercept = I’/s slope = s/b

15 Deriving the IS Function Four-Sector Injection = Withdrawal I + G + X = S + T + M r Y J J = G’ + X’ + I’ - br x-intercept = G’+X’+I’ slope = 1/b b = I/r J = W * IS x-intercept slope = s/b W = S’ - sT’ + T’ + M’ + sY *

16 Deriving the IS Function Three-Sector (w/ b = 0) Injection = Withdrawal I + G = S + T r W JY J = I’ + G’ b = 0 = I/r slope =1/b =  * * IS: slope = s/b =  Y = x-intercept = What happens when there’s G’?

17 Deriving the IS Function Three-Sector (w/ b = ) Injection = Withdrawal I + G = S + T W Y J r b =  = I/r slope = 1/b =0 r is a constant ** IS slope = s/b = 0 What happens when there’s G’?

18 Deriving the IS Function Three-Sector (w/ s = 0) Injection = Withdrawal I + G = S + T S = S’ s = S/Y = 0 slope = 0 W = S’ + T’ Y W J r ** IS slope = s/b = 0 What happens when there’s G’?

19 Deriving the IS Function Three-Sector (w/ s = ) Injection = Withdrawal I + G = S + T r W J Y s= S/Y=  slope =  * * IS slope = s/b =  What happens when there’s G’?

20 Deriving the LM Function Ms = Md = Ma + Mt e =  Liquidity Trap r Y Mt Ma e = Ma/r = slope = 1/e = 0 ** LM slope = d/e = 0 What happens when there’s Ms’?

21 Deriving the LM Function Ms = Md = Ma + Mt d = 0 r Y Mt Ma d = Mt/Y = 0 slope = 0 ** LM slope = d/e =0 What happens when there’s Ms’?

22 Deriving the LM Function Ms = Md = Ma + Mt e = 0 r Y Mt Ma e = Ma/r = 0 slope = 1/e =  * * LM slope = d/e = What happens when there’s Ms’?

23 Deriving the LM Function Ms = Md = Ma + Mt d =  r Y Mt Ma d = Mt/Y =  slope =  * * LM slope = d/e =  What happens when there’s Ms’?

24 Deriving the LM Function Ms = Md = Ma + Mt e =  when r  to a low level  liquidity trap r Y Mt Ma * * LM slope = d/e * LM slope = d/e = 0

A#13 Which of the following correctly explains the rightward shift of the asset demand function from MA0 to MA1? A. a rise in the interest rate B. a rise in the marginal efficiency of investment C. an increase in the sale of government bonds D. a rise in the risk of holding bonds Asset demand for money Interest RateMA 0 MA 1

A#30 Refer to the diagram below: Which of the following statements is INCORRECT? A. The expenditure multiplier will increase B. The IS curve will shift to the right. C. The average propensity to save will increase D. There will be a rise in realized injection S I+G (I+G)’ Y S, I, G S = saving I = investment G = government expenditure Y = income

A#5 A monetary policy will be more effective if the liquidity preference function is more ___ and the marginal efficiency of capital function is more ___. A. elastic, elastic B. inelastic, inelastic C. inelastic, elastic D. elastic, inelastic

A#8 An increase in money supply will be likely to lead to an increase in national income. Which of the following would affect the extent of the change in national income? (1) the interest elasticity of investment (2) the marginal propensity of withdraw (3) the interest elasticity of demand for money A. (1) and (2) only B. (1) and (3) only C. (2) and (3) only D. All of the above

A#2 Which of the following will have a greater impact upon equilibrium income when there is a change in the money supply? A. the flatter the money demand curve; the steeper the investment demand curve; and the larger the MPC B. the steeper the money demand and investment demand curves; and the smaller the MPC C. the flatter the money demand and investment demand curves; and the larger the MPC D. the steeper the money demand curve; the flatter the investment demand curve; ;and the larger the MPC

A#5 There ’ re 3 hypothetical economies. They ’ ve different sets of IS and LM function IS FunctionLM Function Economy AY = rY = r Economy BY = rY = r Economy CY = 2400Y = r Suppose the central banks of the 3 economies reduce the money supply by the same amount. The national income will decrease most in __ and least in __. A. Economy A, Economy BB. Economy A, Economy C C. Economy B, Economy CD. Economy C, Economy A