1. CHAPTER 14 IS-LM Frame work & Equilibrium

2. Chapter Outline The IS-LM framework & equilibrium Development of the IS curve (from ch. 12 pg 140-144) Development of the LM curve (from ch. 13 pg. 177-180 Shifts in the IS curve Changes in real spending Changes in govt. spending Changes in the taxes Other Variables Equilibrium in money markets

3. Chapter Outline cont. Shifts in the LM curve Changes in monetary policy Fiscal and monetary policy Automatic stabilizers Discretionary fiscal policy ‘Crowding out’ effect

4. Development of the IS curve IS curve shows alternative combinations of the real interest rate (r) and real income (Y) such that the market for goods & services is in equilibrium The IS curve is downward sloping r IS Y

5. Deriving the IS curve Interest-related expenditure function (IRE) At an interest rate of r 1 -5%, IRE is at e 1 -80 mil. When rate of interest drops to r 2 -4%, IRE increases to e 2 - 100 mil. IRE = Interest-sensitive consumption and investment spending IRE e1e1 e2e2 r r2r2 A B r1r1

6. Deriving…. The effect of the increase in IRE resulting from a lower r can be shown as an increase in aggregate expenditures (e)  In rate of interest  In IRE (earlier graph)  In Aggregate Expenditures (shifting e 1 to e 2 )  In income level IS curve is shown in Panel (2) which relates real interest rate and real income combinations reflecting equilibrium points in panel (1) – A and B (2) e1e1 B Y Y r1r1 Y2Y2 Y1Y1 Y2Y2 Y1Y1 r2r2 r A e2e2 e1e1 Y IS (1)A B Y

7. Effect of an increase in G If G increases Aggregate expenditures curve shifts from e 1 to e 2 Income level increases from Y 1 to Y 2 Rate of interest does not change Thus, IS curve shifts to the right (IS 1 to IS 2 ) Interest rate remains fixed at r 1 Y e2e2 e1e1 Y A B Y2Y2 Y1Y1 Y1Y1 Y2Y2 r1r1 r IS 1 IS 2 A

8. Development of the LM curve LM (Liquidity-money) curve shows alternative combinations of the interest rate and real income such that the money market is in equilibrium r o Y LM

9. Deriving LM curve Money market is in equilibrium at Point A with interest rate r1 Now suppose that income increases. This will shift the demand curve for money from D 1 to D 2. D 1 corresponds to income level Y 1 and D 2 corresponds to Y 2 Interest rate goes up to r 2 LM curve shows equilibrium points A and B in the money market r2r2 r r1r1 r2r2 r1r1 D2D2 D1D1 M/P 1 M/PY2Y2 Y1Y1 Y A B LMRLMS A B

10. Effect of an increase in money supply  In money supply by FED  In interest rate to r 2 Income level remains constant at Y 1 LM 1 curve shifts to LM 2 r1r1 r2r2 r1r1 r2r2 MS 1 M/PY1Y1 Y A B LM 1 RLMS 1 A B MS 2 LM 2 RLMS 2

11. Effect of an increase in Price level Draw Graph and Explain.

12. Equilibrium in IS-LM framework This Equilibrium shows the level of interest rate and real income where there is simultaneous equilibrium in both money market and the market for goods and services MSMS O rere IS A r YeYe Y

13. Effect of an increase in G  In G  Shift in IS 1, curve to IS 2  New equilibrium at point B  Interest rate (r 1 to r2 )  Income level (Y 1 to Y 2 ) r2r2 r IS 1 IS 2 A B C Y1Y1 Y2Y2 Y3Y3 Y r1r1 LM

14. Effect of an increase in G…. Crowding out refers to a decrease in IRE that occurs when interest rate rises due to an increase in G When government borrows funds to finance increase in G in the financial market, interest rate goes up due to an increase in demand. The difference between point C and B shows crowding out effect

15. Effect of an increase in Money Supply  In money supply by Fed shift in LM curve  In interest rate  In income level A B LM 1 LM 2 r1r1 r2r2 Y1Y1 Y2Y2 IS o