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Goods and Financial Markets1: IS-LM • Goal: link the goods and the financial markets into a more general model that will determine the equilibrium Y and the equilibrium i in the economy in the short run (with fixed prices) • The goods market will be represented by the IS curve (standing for investment-savings) • The financial markets (money market) will be represented by the LM curve (liquiditymoney) 1. TheBlCh5 Hicks-Hansen model based on Keynes’ General Theory 1 The goods market - IS curve • Equilibrium condition Y = Z C + I + G • Investment will provide the link to the financial markets • Determinants of investment: – If sales increase, producers might want to increase their productive capacity Y – If the rate of interest rate i increases, producers find that borrowing to add new capital becomes more expensive + - BlCh5 I I(Y,i) 2 • Equilibrium in the goods market becomes: Y = C(Y-T)+I(Y,i) + G • Basically – When i – When i I I and Ye and Ye • The ZZ curve shifts as the interest rate changes and a multiplier effect takes place – If MPI is the marginal propensity to invest out of new income, assume that MPC + MPI < 1 – The slope of the ZZ curve is MPC + MPI and the interest rate is included in the intercept BlCh5 3 Construction of the IS curve Y=Z Z i Y’e i i’ Ye When the interest rate increases, I (Y, i) drops ZZ’(i’) and the ZZ curve shifts down. The economy contracts from Ye to Y’e. Y E’ E i BlCh5 ZZ(i) IS Y’e Ye E and E’ correspond to 2 combinations of i and Y, such that the good market is in equilibrium. Y 4 The IS curve • Y = C(Y-T)+I(Y, i) + G • Definition: All the combinations of i and Y such that the goods market is in equilibrium i.e. the above equation is satisfied • Shift of the IS: A change in any of the exogenous variables in the equation will cause IS to shift. – Shift variables: • c0 and I0 (confidence variables) • T and G (policy - fiscal - variables) BlCh5 5 Expansionary fiscal policy: increase in G Y=Z Z ZZ’(G+∆G) ZZ (G) ∆G Ye Y Y’e i E i E’ IS’ IS BlCh5 Ye Y’e Y When G increases, ZZ shifts up and IS shifts to the right. An increase in T would has the opposite effect as it is contractionary. 6 Shifts of IS i G T c0 I0 G T c0 I0 IS Y BlCh5 7 The financial markets - LM curve • Equilibrium condition1: supply of money = demand for money Ms = PYL(i) or Ms/P = YL(i) (Ms/P is the real money supply) • It is clear that both LM and IS are relations between i and Y 1. The bonds market is automatically in equilibrium when the money market is in equilibrium BlCh5 8 Construction of the LM curve Ms i i LM E’ i1 i0 BlCh5 M’d(Y1>Y0) Md(Y0) M/P E Y0 Y1 Y 9 The LM curve • Ms = PYL(i) • Definition: All the combinations of i and Y such that the financial markets (bonds and money) are in equilibrium • Shift of the LM curve: a change in the money supply or a change in price or an exogenous shift in the money demand – An increase in the money supply ( or a decrease in price) is expansionary – A change in the velocity of money BlCh5 10 Expansionary monetary policy: an increase in Ms Ms M’s i i LM LM’ A i0 i1 Md(Y0) M/P BlCh5 A’ Y0 Y1 Y 11 Shifts of LM i LM Ms P V Ms P V Y BlCh5 12