Survey
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
Real bills doctrine wikipedia , lookup
Economic bubble wikipedia , lookup
Modern Monetary Theory wikipedia , lookup
Monetary policy wikipedia , lookup
Nominal rigidity wikipedia , lookup
Exchange rate wikipedia , lookup
Ragnar Nurkse's balanced growth theory wikipedia , lookup
Fei–Ranis model of economic growth wikipedia , lookup
Interest rate wikipedia , lookup
Money supply wikipedia , lookup
Purpose of the IS-LM framework To explain general equilibrium of the economy using the three markets Labor market Goods market and Money market To explain response of the economy against any shock While using the IS-LM framework to understand the general equilibrium of the economy we shall, in this lecture, assume that the economy is closed (just to keep things simple). 2 The FE line: equilibrium in the labor market r FE line Y 3 Shift of FE line A beneficial supply shock will shift the FE line to the right. On the other hand, an adverse supply shock will shift the FE line to the left r Adverse supply shock Favorable supply shock FE line Y 4 The IS curve: equilibrium in the goods market The goods market is in equilibrium when savings is equal to investment. The IS curve shows the real interest rate for which the goods market is in equilibrium. The IS curve is so called because at all points on it savings is equal to investment The IS curve slopes downward because if output (income) increases, savings also increases reducing the interest rate and vice versa. For constant output, any change in the economy that changes national savings relative to investment will change the interest rate that clears the market and shift the IS curve. We plot IS curve only by changing savings curve (NOT investment curve), because savings determine the level of investment. 5 The IS curve r r I S1 IS S2 D D 7% F 5% F S, I Y1 Y2 Y 6 Shift of the IS curve: an example 1. A decrease in expenditure increases savings 2. and reduces interest rate r r S1 I IS2 S2 r1 4. Therefore, IS1 shifts to the left to IS2 to match the constant output level IS1 A A B r2 B* B S, I Y* 3. But the output is fixed at Y* Y 7 Factors that shift IS curve An increase in Shifts the IS curve Reason Expected future output Up and to the right Wealth Up and to the right Government purchases Up and to the right Expected future MPK Up and to the right Investment increases, interest rate rises Tax No change (Ricardian Equivalence) If the consumers think that in future they will get an equivalent amount of tax-cut Consumption rises, savings falls, interest rate rises Down and to the left If the consumers reduce consumption because of the tax 8 The LM curve: equilibrium in the asset market From the study of asset market we know that equilibrium in the asset market will be established at the point where demand for and supply of asset will be equal. We also found that this condition can be reduced to: Equilibrium at the point where demand for and supply of money will be equal. Demand for money depends on interest rate paid to nonmonetary assets. If interest rate on nonmonetary assets rise people will hold more nonmonetary assets and lesser money. This means that there is an inverse relationship between demand for money and interest rate. For this reason, the demand for money curve always slopes downward. On the other hand, as the money supply is fixed, it is always vertical irrespective of the interest rate. The LM curve, like the IS curve, represents a locus of equilibrium points of the money market at various interest rates. LM curve is called so because on all points of the curve the demand for money (L) is equal to the supply of money (M). In our closed economy, we assume that money supply is determined by Bangladesh Bank and is fixed. Therefore, determination of equilibrium will depend on the demand for money. 9 The LM curve r r M/P LM C C r2 r1 A A M1/P Y1 Y2 At output level Y1 equilibrium is at point A and equilibrium interest rate is r1. If output level changes to Y2 it will increase demand for money and equilibrium will be established at point C where the equilibrium interest rate will be r2. Interest rate rises because by increasing interest rate the excess demand for money imposed by the increased level of output can be offset. Y 10 Shift of the LM curve For constant output, any change in the real money supply relative to real money demand will change the real interest rate and cause the LM curve to shift. r r MS1 LM1 MS2 LM2 r1 r2 MD M1/P M2/P Y Y* 11 Shift of the LM curve For constant output, any change in the real money demand relative to real money supply will change the real interest rate and cause the LM curve to shift. r r LM1 MS LM2 r1 r2 MD1 MD2 Y Y* 12 Factors that shift the LM curve An increase in Shifts the LM curve Reason M Down and to the right Reduces r as M/P increases P Up and to the left Increases r as M/P falls Down and to the right Reduces r as demand for money falls Wealth Up and to the left Demand for money increases and r increases Payment technology Down and to the right Demand for money falls and r falls 13 General equilibrium in the IS-LM model The whole economy comes to a general equilibrium when all the three markets (labor market, goods market and the asset market) come to equilibrium at the same time. r IS FE LM General Equilibrium point Y 14 Effect of a change on the IS-LM framework r • The initial general equilibrium is at point E IS FE LM E Y 15 Effects of a change in the IS-LM framework A 10% increase in the money supply will shift the LM curve to the right. IS and LM curves meet at F, but the FE line does not. At F people will want more goods and firms will respond. r IS FE LM1 LM2 E F Y1 Y 16 Effects of a change in the IS-LM framework But as the firms are out of the FE line they will want to go back to it. To do so they will push the price up so that LM curve shifts back again to E. r IS FE LM1 LM2 E F Y 17 Effects of a change in the IS-LM framework Suppose money supply changes by 10%. Price level is fixed. This change will shift the LM curve to the right and bring down the interest rate. The IS and LM curves meet at a new point. But the FE line stays the same. If we assume that asset and goods market adjust more quickly than the labor market then output will be at the new point. This will be so because at the lower interest rate people will consume more and firms will invest more. But this point is not optimum for the firms as this is out of the FE line. Therefore, firms will want to go back to FE line and will push price up to do so. This action of the firm will set the equilibrium at the original point. The only difference will be that the price level will higher by 10%. 18 General equilibrium in the IS-LM framework: Classical vs. Keynesian debate We have seen that an increase in the money supply will reduce the interest rate and shift the LM curve to the right to intersect the IS curve in a new point, where a temporary equilibrium only in the goods and asset market will be established. The labor market will not be in this equilibrium and consequently firms will push the price up to return to the general equilibrium state. The question is how fast this adjustment process takes place? According to the Classical view the adjustment process takes place very quickly. On the other hand, the Keynesian view proposes that the adjustment process may take long time and as a result the state out of general equilibrium may persist for a long time. About the monetary neutrality, both agrees. The difference in their view is that- the Classical economists thinks money is always neutral and the Keynesians think that money is neutral but takes a considerable time to be neutral. 19 Aggregate Demand (AD) and Aggregate Supply (AS) model AD-AS model is equivalent to the IS-LM model. The difference between the two is that the IS-LM model relates output (Y) with the interest rate (r); whereas the AD-AS model relates output (Y) with the price level. IS-LM model is useful when we need to look at the effect of a change in the interest rate on important variables like savings and investment. AD-AS model is useful to analyze variables that are directly related to the price level such as inflation and unemployment. 20 Aggregate demand curve The aggregate demand curve shows the relationship between the aggregate quantity of goods demanded and the price level. The intersection point of the IS and the LM curves determine the aggregate demand for goods. Therefore, if the IS or the LM curve shifts it will indicate a different price level and a different aggregate quantity demanded. At the intersection of IS and LM1, Y1 output will be demanded. But if the price level increases it will shift the LM curve up and to the left and the corresponding intersection point will show a reduced level of output, Y2. r LM2 LM1 IS Y P P2 P1 AD Y2 Y1 Y 21 Shift of the AD curve r LM For any given price level, any change in the quantity demanded will shift the AD curve. For example, if the government reduces expenditure it will shift the IS curve to the left. For constant price level this will result in a shift of the Ad curve. Any factor that shifts the IS-LM intersection point to the left will shift the AD curve to the left and vice versa. IS1 IS2 Y P P1 AD1 AD2 Y2 Y1 Y 22 Factors that shift the AD curve Some factors that shift the AD curve to the right: Increase in expected future output Increase in wealth Increase in government expenditure Increase in expected future MPK Increase in the nominal money supply Rise in expected inflation 23 Aggregate supply (AS) curve The AS curve shows the relationship between the price level and the aggregate amount of output that firms supply. In reality firms’ supply actions are different than our theoretical model of supply studied in microeconomics. Our assumptions for aggregate supply are1. Prices remain fixed in the short run and firms supply the quantity of output at that fixed price level. 2. In the long run price and wages adjust fully and market clears completely. Therefore, in the long run the market is in full employment level. Assumption 1 indicates that our short run aggregate supply (SRAS) curve is horizontal. Assumption 2 indicates that out long run aggregate supply (LRAS) is vertical. 24 SRAS curve in the Keynesian view P LRAS SRAS Y 25 Equilibrium in the AD-AS model P 1. In the AD-AS model long run equilibrium will be established at the point where LRAS, SRAS and AD meet (point E in the graph) LRAS E SRAS 2. Output will be at the full employment level. AD Y 26 SRAS curve in the classical view The horizontal SRAS curve is proposed by the Keynesians. The classical economists does not agree to this. According to classical view prices adjust quickly and therefore horizontal SRAS does not exist. Classical view proposes the usual left to right upward moving SRAS. However, they agree with the vertical LRAS. P LRAS SRAS Y 27