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**Goods and Financial Markets Together: The IS-LM Model**

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**The Goods Market and the IS Relation**

Equilibrium in the goods market exists when production, Y, is equal to the demand for goods, Z. In the simple model (in chapter 3), the interest rate did not affect the demand for goods. The equilibrium condition was given by:

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**Investment, Sales (Y), and the Interest Rate (i)**

Now, we no longer assume I (investment) is constant We capture the effects of two factors affecting investment: The level of sales/income (+) The interest rate (-)

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**The Determination of Output**

Taking into account the investment relation above, the equilibrium condition in the goods market becomes:

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**The Determination of Output**

Equilibrium in the Goods Market The demand for goods is an increasing function of output. Equilibrium requires that the demand for goods be equal to output. When the ZZ line is flatter than the 45-degree line, an increase in output leads to a less than one-for-one increase in demand.

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Deriving the IS Curve The Effects of an Increase in the Interest Rate on Output An increase in the interest rate decreases the demand for goods at any level of output. When the ZZ line is flatter than the 45-degree line, an increase in output leads to a less than one-for-one increase in demand.

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The IS Curve Shifts of the IS Curve An increase in taxes...

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**Financial Markets and the LM Relation**

The interest rate is determined by the equality of the supply of and the demand for money: M = nominal money stock $YL(i) = demand for money $Y = nominal income i = nominal interest rate

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**Real Money, Real Income, and the Interest Rate**

The LM relation: In equilibrium, the real money supply is equal to the real money demand, which depends on real income, Y, and the interest rate, i: Recall: before, we had the same equation but in nominal instead of real terms (nominal income and nominal money supply). Dividing both sides by P (the price level) gives us the equation above.

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Deriving the LM Curve The Effects of an Increase in Income on the Interest Rate

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Shifts of the LM Curve Shifts of the LM Curve An increase in money...

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**The IS and the LM Relations Together**

The IS-LM Model Equilibrium in the goods market (IS). Equilibrium in financial markets (LM). When the IS curve intersects the LM curve, both goods and financial markets are in equilibrium.

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**Fiscal Policy, the Interest Rate and the IS Curve**

Fiscal contraction: a fiscal policy that reduces the budget deficit. Reducing G or increasing T Fiscal expansion: increasing the budget deficit. Increasing G or decreasing T Taxes (T) and government expenditures (G) affect the IS curve, not the LM curve.

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**Fiscal Policy, the Interest Rate and the IS Curve**

The Effects of an Increase in Taxes

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**Monetary Policy, the Interest Rate, and the LM Curve**

Monetary contraction (tightening) refers to a decrease in the money supply. An increase in the money supply is called monetary expansion. Monetary policy affects only the LM curve, not the IS curve.

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**Monetary Policy, the Interest Rate, and the LM Curve**

The Effects of a Monetary Expansion

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**Recent U.S. Monetary Policy**

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**Movement in Interest Rate**

Using a Policy Mix The Effects of Fiscal and Monetary Policy. Shift of IS Shift of LM Movement of Output Movement in Interest Rate Increase in taxes left none down Decrease in taxes right up Increase in spending Decrease in spending Increase in money Decrease in money

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**German Unification and the German Monetary-Fiscal Policy Mix**

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**U.S. Money Supply during the Great Depression (1928-1936)**

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**U.S. Fiscal Policy during the Great Depression (1930-1947)**

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The U.S. Recession of 2001

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Mr. Greenspan:

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1 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Prepared by: Fernando Quijano & Shelly Tefft.

1 of 39 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Prepared by: Fernando Quijano & Shelly Tefft.

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