Presentation on theme: "Department of Economics DA COLLEGE FOR WOMEN PH-VIII, KARACHI"— Presentation transcript:
1 Department of Economics DA COLLEGE FOR WOMEN PH-VIII, KARACHI IS & LM ModelPresentedbyMUHAMMAD HASEEBAssistant ProfessorDepartment of EconomicsDA COLLEGE FOR WOMEN PH-VIII, KARACHI
2 In this topic you will learn: the IS curve, and its relation to:the Keynesian crossthe LM curve, and its relation to:the theory of liquidity preferencehow the IS-LM model determines income and the interest rate in the short run when P is fixed
3 The IS curvedef: a graph of all combinations of r and Y that result in goods market equilibrium i.e. actual expenditure (output) = planned expenditure The equation for the IS curve is:
4 Deriving the IS curve r I PE Y PE =C +I (r2 )+G PE =C +I (r1 )+G I Y1
5 Why the IS curve is negatively sloped A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending (PE ).To restore equilibrium in the goods market, output (a.k.a. actual expenditure, Y ) must increase.
6 Factors affecting the slope of IS curve Interest sensitivity of investment demand (responsiveness of investment demand due to change in interest rate).Higher the interest sensitivity of investment demand flatter the IS curveMultiplier = 1/(1 – mpc) (for three sector closed economy model with lump sum tax)Higher the mpc (lower mps) higher the multiplier flatter the IS curve
7 Factors that shift the IS Curve Government purchasesTaxesInvestmentWealthExchange rate (for an open economy)
8 Fiscal Policy and the IS curve We can use the IS-LM model to see how fiscal policy (G and T ) affects aggregate demand and output.Let’s start by using the Keynesian cross to see how fiscal policy shifts the IS curve…
9 Shifting the IS curve: G PE =YYPEPE =C +I (r1 )+G2At any value of r, G PE YPE =C +I (r1 )+G1…so the IS curve shifts to the right.The horizontal distance of the IS shift equalsY1Y2rYr1YIS2IS1Y1Y2
10 The Theory of Liquidity Preference Reasons for holding money classified by KEYNES according to motive. He identified the TRANSACTIONS, PRECAUTIONS and SPECULATIVE DEMAND FOR MONEY.A simple theory in which the interest rate is determined by money supply and money demand.
11 Money supply The supply of real money balances is fixed: r M/P interestrateThe supply of real money balances is fixed:We are assuming a fixed supply of real money balances becauseP is fixed by assumption (short-run), and M is an exogenous policy variable.M/Preal money balances
12 Money demand Demand for real money balances: L (r ) r M/P interest rateDemand for real money balances:L (r )M/Preal money balances
13 EquilibriumrinterestrateThe interest rate adjusts to equate the supply and demand for money:r1L (r )M/Preal money balances
14 How central bank raises the interest rate To increase r, Central bank reduces Mr2r1L (r )M/Preal money balances
15 The LM curve Now let’s put Y back into the money demand function: The LM curve is a graph of all combinations of r and Y that equate the supply and demand for real money balances.The equation for the LM curve is:
16 Deriving the LM curve r r L (r , Y2 ) LM Y1 Y2 L (r , Y1 ) r2 r2 r1 r1 (a) The market for real money balances(b) The LM curveM/PrrYL (r , Y2 )LMY1Y2L (r , Y1 )r2r2r1r1
17 Why the LM curve is upward sloping An increase in income raises money demand.Since the supply of real balances is fixed, there is now excess demand in the money market at the initial interest rate.The interest rate must rise to restore equilibrium in the money market.
18 Factors affecting the slope of LM curve Interest sensitivity of money demand (responsiveness of money demand due to change in interest rate).Higher the interest sensitivity of money demand flatter the LM curve
19 Factors that shift the LM Curve Nominal Money SupplyPrice levelExpected InflationAll those factors that change the money demand (increase/decrease of wealth, increase/decrease in the risk of alternative assets, increase/decrease in liquidity of alternative assets and increase and decrease in the efficiency of payment technologies
20 How Money supply shifts the LM curve (a) The market for real money balances(b) The LM curveM/PrrYLM2L (r , Y1 )Y1LM1r2r2r1r1
21 The short-run equilibrium The short-run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods & money markets:YrLMISEquilibriuminterestrateEquilibriumlevel ofincome
22 Fiscal Policy An increase in Government Spending We begin by examining how changes in fiscal policy (taxes and spending) alter the economy’s short-run equilibrium.An increase in government spending is represented in the next slide.The equilibrium of the economy moves from point A to point B. Income rises from Y1 to Y2 and the real interest rate rises from r1 to r2.When the government increases its spending, total income Y begins to rise (from the Keynesian cross model). As Y rises, the economy’s demand for money rises and so, assuming that the supply of real balances is fixed, the interest rate r begins to rise. As r rises, I falls thus partially offsetting the effects of the increased government spending.
23 Fiscal Policy An increase in Government Spending
24 Fiscal Policy An increase in Government Spending The increased government spending has “crowded-out” some of the investment spending in the economy.The case of a tax cut is similar. This is represented in the next slide.
26 Monetary Policy An increase in Money Supply We now examine the effects of monetary policy. This is represented in the next slide.Consider an increase in the money supply. An increase in M leads to an increase in M/P since we are assuming that P is fixed. The LM curve shifts downward and the economy moves from point A to point B. The increase in the money supply lowers the interest rate and raises the level of income.This is because the increase in M/P lowers r and this causes I to increase since I is inversely related to r. This, in turn, increases planned expenditure, production and income Y.This process is called the “monetary transmission mechanism”.
28 Fiscal And Monetary Interaction We can now consider simultaneous fiscal and monetary policy in the IS/LM model in the next slide.Slide (a) shows the effects of a tax increase, holding the real money supply constant.Slide (b) shows the effects of a tax increase, accompanied by a contraction in the real money supply. This keeps the interest rate constant in the economy.Slide (c) shows the effect of the tax cut combined with an expansion of the real money supply. The effect of this policy is to keep the level of income constant in the economy.
30 The Big Picture Keynesian Cross IS curve IS-LM model Explanation of short-run fluctuationsTheory of Liquidity PreferenceLM curveAgg. demand curveModel of Agg. Demand and Agg. SupplyFigure 10-14, p.307.This schematic diagram shows how the different pieces of the theory of short- run fluctuations fit together.Agg. supply curve
31 REFERENCES Macroeconomics 4th Edition by Gregory Mankiw Macroeconomics by 7th Edition Dornbusch & FisherMacroeconomics by 5th Edition Richard T FroyanEconomics 3rd Edition by John SlomanInternet