blch51 goods and financial markets 1 : is-lm goal: link the goods and the financial markets into a...
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BlCh5 1
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 (liquidity-money)
1. The Hicks-Hansen model based on Keynes’ General Theory
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BlCh5 2
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=
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BlCh5 3
• Equilibrium in the goods market becomes:Y =
• Basically – When i I and Ye
– When i I 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
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BlCh5 4
Construction of the IS curve
Z
Y
Y
i
Y’e Ye
YeY’e
i
i’
When the interest rate increases, I (Y, i) drops and the ZZ curve shifts down. The economy contracts from Ye to Y’e.
E and E’ correspond to 2 combinations of i and Y, such that the good market is in equilibrium.
i
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BlCh5 5
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:
• (confidence variables)• (fiscal policy variables)
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BlCh5 6
Expansionary fiscal policy: increase in G
Z
Y
Y
i
Ye
Ye
Y=Z
ZZ (G)
i E
IS
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.
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BlCh5 7
Shifts of IS
i
Y
IS
GTc0
I0
GTc0
I0
Expansionary
Contractionary
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BlCh5 8
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
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BlCh5 9
Construction of the LM curve
ii
M/P Y
Ms
Y0 Y1
i0
Md(Y0)
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BlCh5 10
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
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BlCh5 11
Expansionary monetary policy: an increase in Ms
A
ii
M/P Y
Md(Y0)
Y0
i0
Ms
LM
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BlCh5 12
Shifts of LM
Y
iLM
Ms
PV
Ms
PV
Expansio
nary
Contracti
onary
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BlCh5 13
The IS-LM model
Y = IS curveM/P = LM curveIS is 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
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BlCh5 14
The IS-LM graph
i
Y
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BlCh5 15
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
IS
LM
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BlCh5 16
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
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BlCh5 17
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
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BlCh5 18
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
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BlCh5 19
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
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BlCh5 20
A fiscal expansion
i
ie
YYe
LM
IS
A
The economy moves along the LM curve from A to A’
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BlCh5 21
Mechanics of fiscal expansionGoods market effects
As G Y = too immediatelyThen C= and I = alsoMultiplier effect: at same i, Y reaches a higher level as IS shifts to the right
Financial markets effectsAs 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’.
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BlCh5 22
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.
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BlCh5 23
Z
Y
Y
i
Ye Y”
Ye
Y=Z
ZZ (G)
i
∆G
IS
LMi
M/P
Ms
Md
i
i’
Y’e
i’
ExpansionaryFiscalPolicy
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BlCh5 24
Net effect of increase in G on investment
1. Using investmt functas Y increases I
as i increases I Net effect is ambiguous
2. Using equil condition
as Y increases Sp as G increases (T - G)
Net effect is ambiguous
€
I =
€
I =
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BlCh5 25
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%
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BlCh5 26
Calculate the corresponding equilibrium for C & IC = 200 + .25Y - .25T = 200 + 300 - 50 = 450I = 150 + .25Y - 1000i = 150 + 300 - 100 = 350Y = C + I + G = 450 + 350 + 400 = 1200Impact 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.
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BlCh5 27
Monetary policy• Instrument:
• Curve affected:
• Effect:
Expansionary when Ms increases
LM shifts to the
Contractionary when Ms is cut
LM shifts to the
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BlCh5 28
A monetary contraction
LM
IS
i
Y
A
Ye
ie
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BlCh5 29
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 = .
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BlCh5 30
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.
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BlCh5 31
i
M/PY
iMsM’s
IS
LM
Mdi
Ye
A monetary contraction
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BlCh5 32
Problem #5 cont.g. Monetary expansion: M/P increases to 1840Same IS curve: Y = 1100 - 2000iNew LM curve: 2Y - 8000i = 1840i = Y/4000 - 1840/8000i = Y/4000 - .23Solve the IS-LM system:Y = 1100 - 2000(Y/4000 - .23)Y = 1100 - .5Y - 4601.5 Y = 1560 so Y = 1040
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BlCh5 33
Replace in LM:i = 1040/4000 - .23 so i = .03 or 3% Solve for C and IC = 410 and I = 380A monetary expansion reduces i
and increases YThus C (function of Y) increases and I (function of Y and of i) increases
unambiguously.
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BlCh5 34
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
Y
IS
LM
Rational:
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BlCh5 35
• To dampen the inflationary impact of an expansionary fiscal policy, use at the same time contractionary monetary policy.
i
Y
IS
LM
Policy Mix 2
Rational: