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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 and the equilibrium in the economy (with prices) • The goods market will be represented by the curve (standing for investment-savings) • The financial markets (money market) will be represented by the curve (liquiditymoney) BlCh5 1. The Hicks-Hansen model based on Keynes’ General Theory 1 The goods market - IS curve • Equilibrium condition • will provide the link to the financial markets • Determinants of investment: – If increase, producers might want to increase their productive capacity by investing in capital goods. – If , producers find that borrowing to add new capital becomes more expensive I BlCh5 2 • Equilibrium in the goods market becomes: Y= • Basically – When i – When i I I and Ye and Ye • The ZZ curve shifts now 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 now and the interest rate is included in the intercept BlCh5 3 Construction of the IS curve Z When the interest rate increases, I (Y, i) drops and the ZZ curve shifts down. The economy contracts from Ye to Y’e. i Y’e Ye Y i i’ i BlCh5 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= • Definition: All the combinations i.e. the above equation is satisfied • Shift of the IS: A change in any of the in the equation will cause IS to shift. – Shift variables: • • BlCh5 (confidence variables) (fiscal policy variables) 5 Expansionary fiscal policy: increase in G Y=Z Z ZZ (G) Y Ye i E i IS BlCh5 Ye Y When G increases by ∆G, 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 Expansionary i G T c0 I0 Contractionary G T c0 I0 IS Y BlCh5 7 The financial markets - LM curve • Equilibrium condition1: supply of money = demand for money Ms = or Ms/P = (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 i0 Md(Y0) M/P BlCh5 Y0 Y1 Y 9 The LM curve • Ms = • Definition: All the combinations of and such that the ( and ) are in equilibrium • Shift of the LM curve: a change in the money or a change in or an exogenous shift in the money demand – An in the money supply ( or a in price) is expansionary – A change in the velocity of money BlCh5 10 Expansionary monetary policy: an increase in Ms Ms i i A i0 Md(Y0) M/P BlCh5 LM Y0 Y 11 Shifts of LM i LM Ms P V Ms P V Y BlCh5 12 The IS-LM model Y= M/P = IS is IS curve LM curve sloped and LM is sloped, they will intercept in E determining Y and i in equilibrium. At that point, all three markets : two financial markets and the goods market, are BlCh5 13 The IS-LM graph i Y BlCh5 14 Problem # 4 IS-LM model: C = 200+ .25YD I = 150 + .25Y - 1000i G = 250 and T = 200 (M/P)d = 2Y - 8000i M/P = 1,600 BlCh5 IS LM 15 a. Derive the IS curve: Y = C + I + G Y = 200 + .25Y- .25T + 150 + .25Y - 1000i + 250 = 550 + .5Y - 1000i Y - .5Y = 550 - 1000i Y (1 - .5) = 550 - 1000i Y = [1/.5] (550 -1000i) multiplier = 2 IS curve: Y = 1100 - 2000i BlCh5 16 b. Derive the LM curve: YL(i) = M/P 2Y - 8000i = 1600 8000i = 2Y - 1600 LM curve: i = Y/4000 - .2 c. Solve IS-LM for equilibrium Y Y = 1100 -2000i = 1100 - 2000(Y/4000 - .2) = 1100 - .5Y + 400 1.5Y = 1500 so Y = 1000 BlCh5 17 d. i = Y/4000 - .2 = 1000/4000 - .2 = .25 - .2 = .05 so i = 5% e. Replace equilibrium Y and i into C and I C = 200 + .25*1000 - .25*200 = 400 I = 150 + .25*1000 - 1000*.05 = 350 G = 250 So Y = 400 + 350 + 250 = 1000 BlCh5 18 Fiscal Policy • Instruments: • Curve affected: • Effect: Expansionary: when (G-T) or G or T IS shifts to the Contractionary: when (G-T) or G or T IS shifts to the BlCh5 19 A fiscal expansion i LM ie The economy moves along the LM curve from A to A’ A IS Ye BlCh5 Y 20 Mechanics of fiscal expansion Goods market effects As G Y= too immediately Then C= and I = also Multiplier effect: at same i, Y reaches a higher level as IS shifts to the right Financial markets effects As Y the demand for money M = and the ward shift in Md results in a i, but this is a movement along the curve to A’. BlCh5 21 Effect on investment As i increases, investment is . So there are 2 opposite effects on investment as Y increases I as i increases I It means that the overall expansion due to the increase in G will be by the impact of the increase in the interest rate on investment. There is some of private investment due to the increase in government spending. BlCh5 22 Expansionary Fiscal Policy Y=Z Z ZZ (G) ∆G i Ye Ms LM i i’ i’ i i Md BlCh5 Y Y” IS M/P Ye Y’e Y 23 Net effect of increase in G on investment I 1. Using investmt funct as Y increases I as i increases I Net effect is ambiguous I 2. Using equil condition as Y increases Sp as G increases (T - G) Net effect is ambiguous BlCh5 24 Problem # 5 cont. g. A fiscal expansion: G increases to 400 New IS curve: Y = 700 + .5Y - 1000i Y = [1/.5] (700 - 1000i) = 1400 - 2000i Same LM curve: i = Y/4000 - .2 Solve: Y = 1400 - 2000(Y/4000 - .2) 1.5Y = 1800 so Y = 1200 Replace in LM and we get i = .10 or 10% BlCh5 25 Calculate the corresponding equilibrium for C & I C = 200 + .25Y - .25T = 200 + 300 - 50 = 450 I = 150 + .25Y - 1000i = 150 + 300 - 100 = 350 Y = C + I + G = 450 + 350 + 400 = 1200 Impact of fiscal expansion: both Y and i increase. C (a function of Y) increases too. I increases when Y increases and decreases when i increases (ambiguous results overall). With these data, I does not change as the two effects neutralize each other. BlCh5 26 Monetary policy • Instrument: • Curve affected: • Effect: Expansionary when Ms increases LM shifts to the Contractionary when Ms is cut LM shifts to the BlCh5 27 A monetary contraction i LM ie A IS Ye BlCh5 Y 28 Mechanics of a monetary contraction • Open market of bonds • Suppose P=1 constant - so monetary contraction in terms is equivalent to a terms one. Financial market effects As Ms drops, i - money market effect. Goods market effects As i increases, investment I = I(Y,i) is affected and Y = . BlCh5 29 Effect on investment Unambiguous: as Y drops and i increases, investment can only . Note that the money demand will shift to the left as Y drops dampening the extent of the increase in the interest rate on the fall of I and subsequently on the fall of Y. BlCh5 30 A monetary contraction M’s i Ms i IS LM i Md M/P BlCh5 Ye Y 31 Problem #5 cont. g. Monetary expansion: M/P increases to 1840 Same IS curve: Y = 1100 - 2000i New LM curve: 2Y - 8000i = 1840 i = Y/4000 - 1840/8000 i = Y/4000 - .23 Solve the IS-LM system: Y = 1100 - 2000(Y/4000 - .23) Y = 1100 - .5Y - 460 1.5 Y = 1560 so Y = 1040 BlCh5 32 Replace in LM: i = 1040/4000 - .23 so i = .03 or 3% Solve for C and I C = 410 and I = 380 A monetary expansion reduces i and increases Y Thus C (function of Y) increases and I (function of Y and of i) increases unambiguously. BlCh5 33 Policy Mix 1 • To maximize the expansionary (or contractionary) impact on the economy, use both expansionary monetary and expansionary fiscal policy (or both contractionary). i LM IS Y Rational: BlCh5 34 Policy Mix 2 • To dampen the inflationary impact of an expansionary fiscal policy, use at the same time contractionary monetary policy. Rational: BlCh5 i LM IS Y 35