Download PRESENTATION 6. The IS

Macroeconomic equilibrium in the
real and in the monetary sector:
The IS-LM model
Frederick
University
2014
Macroeconomic equilibrium in
the money market
i
LM – curve of the equilibrium on the money sector
On each point of the curve MS = MD
MD1
MD2 MS
i2
i1
Income rises and MD increases
LM
i
i1
M/P
Y1
Y2
The equilibrium interest rate increases
Y
Analysing the LM curve
The slope of the curve depends on the EMD as regard Y
i
LM
The slope of the LM curve depends on
The elasticity of MD as regard income and on
The elasticity of MD as regard interest rate
If the Ey is high and the Ei is low, the curve is steep
y
Analysing theAll LM
curve
the points on LM present an equilibrium
A’
i
i1
on the money market (MS = MD) and show
what should the interest rate (i) be
at the given level of income (Y),
so that MS = MD
If the economy is in point A, the
i is too low for the given y. At this low
interest rate the public will want
to hold more liquidity. MD > MS.
Therefore, they will start selling their
bonds in order to get more liquidity.
The supply of bonds will increase and
the interest rate will rise.
A
LM
y1
Y
Factors, determining LM
i

MS MS
1
LM1
i
MS2
LM2
i1
i1
MD
A1
i2
i2
A2
M/P
Y
Y
MS increase and the equilibrium interest rate falls. At the same level of income,
MS = MD at a lower interest rate. LM shifts to the right
Factors, determining LM
LM
2

i
MDMS
i
MD2
LM1
A2
i2
i1
i1
A1
i2
MD1
M/P
Y
Y
MD increase and the equilibrium interest rate rises. At the same level of income,
MS = MD at a higher interest rate. LM shifts leftwards
Macroeconomic equilibrium in the
real sector




Investment demand depends on the
interest rate
Savings depend on income
Therefore, there is not a single variable
to clear the capital market
The equilibrium in the capital market
depends on both income (Y) and
interest rate (i)
Macroeconomic equilibrium in
the real
sector
AE
E
2
AE1
AE
IS
Y1
the interest rate falls
And investment spending increases
IS – curve of equilibrium in the real sector
Supply of loanable funds = Demand for loanable funds
АЕ = Y on each point
E1
i
2
Y2
Y
Slope – depends on the elasticity of investment
demand as regards the interest rate
i1
i2
Y
Analysing the IS curve
i
The slope of the IS curve depends on the
elasticity of Investment demand as regard
interest rate
IS
A
If the Ei is low, the curve is steep
A’
All the points on IS present an equilibrium
on the real sector (AE = Y) and show
what should be the income (Y) be at every level of
interest rate (i), so that AE = Y
Y
If the economy is in point A, the Y is too low for the given i. At this low
interest rate businesses will want to invest more. AE > Y. Inventories will
fall and firms will increase orders to suppliers. Income will start rising
until AE = Y at point A’
Factors, determining IS:
Injections andAE Leakages
2
AE1
AE
IS – curve of equilibrium in the real sector
АЕ = Y on each point
Government spending rises at the
same level of interest rate and Y increases
i
IS
i1
i2
Y1
A
Y
Y2
A’
Point A shifts to the right to point A’,
where will be the new equilibrium at i1
The IS curve shifts rightwards
The increase in injections and the decrease in
leakages shift the IS curve to the right.
The decrease in injections and the increase in
leakages shift the IS curve to the left
Y
Equilibrium in the real sector and
in the financial
sector
Increase in exports
IS1
i
IS2
Е2
Е1
i1
Y1
Y2
IS shows what should the income be at every level of i.
LM With the increase in exports, Y rises and IS shifts
rightwards. This destroys the equilibrium in the
monetary sector. LM shows what should the interest rate
be at
every level of Y. At the higher income level Y2 i1 is lower
than the equilibrium i. The public starts selling bonds,
because they prefer more liquidity. MD rises. PV of
bonds falls. PV = FV/f(i). The interest rate rises.
Y In the real sector investment falls, Y decreases and
savings fall too. The new equilibrium is achieved at
point Е2
Equilibrium in the real sector and
in the financial sector
MS increases
i
LM shows what the interest rate should be at every
level of income. The increase in MS reduces the i
at the same income level Y1.
IS
E1
At a lower interest rate, however, I increase and AE > Y.
Inventories fall, Y rises, and S increase, as well.
Е2
At the same time MD increases and the interest rate rises.
LM1
LM2
Y1
Y
The new equilibrium is set at Е2