Macroeconomic equilibrium in the real and in the monetary sector:The IS-LM model

Frederick University

2014

Macroeconomic equilibrium in the money market

i

M/P

MS

MD1

i1

i

YY1

i1

Y2

MD2

i2

LM

Income rises and MD increases The equilibrium interest rate increases

LM – curve of the equilibrium on the money sectorOn each point of the curve MS = MD

Analysing the LM curveThe slope of the curve depends on the EMD as regard

Yi

y

LMThe slope of the LM curve depends on The elasticity of MD as regard income and onThe elasticity of MD as regard interest rate

If the Ey is high and the Ei is low, the curve is steep

Analysing the LM curve

i

Y

LM A

All the points on LM present an equilibriumon the money market (MS = MD) and show what should the interest rate (i) beat the given level of income (Y), so that MS = MD

If the economy is in point A, thei is too low for the given y. At this low interest rate the public will wantto 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.

i1

y1

A’

Factors, determining LM

MSi

M/P

MS1

MD

MS2

i1

i2

i

Y

LM1

i1

Y

i2

LM2

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

A1

A2

Factors, determining LM

MDi

M/P

MS

MD1

MD2

i1

i2

i

Y

LM1

i1

Y

i2

LM2

MD increase and the equilibrium interest rate rises. At the same level of income, MS = MD at a higher interest rate. LM shifts leftwards

A1

A2

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

Y

AE1 the interest rate falls And investment spending increases

Y1

AE2

Y2

i

Y

i1

Y1

i2

Y2

IS

IS – curve of equilibrium in the real sector Supply of loanable funds = Demand for loanable fundsАЕ = Y on each point

Slope – depends on the elasticity of investment demand as regards the interest rate

E1

E2

Analysing the IS curve

i

Y

IS

The slope of the IS curve depends on theelasticity of Investment demand as regard interest rate

If the Ei is low, the curve is steep

All the points on IS present an equilibriumon the real sector (AE = Y) and show what should be the income (Y) be at every level ofinterest rate (i), so that AE = 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’

AA’

Factors, determining IS: Injections and Leakages

AE

Y

AE1

Government spending rises at the same level of interest rate and Y increases

Y1

AE2

Y2

i

Y

i1

Y1

i2

Y2

IS

IS – curve of equilibrium in the real sector АЕ = Y on each point

Point A shifts to the right to point A’, where will be the new equilibrium at i1The IS curve shifts rightwards

AA’

The increase in injections and the decrease inleakages shift the IS curve to the right. The decrease in injections and the increase inleakages shift the IS curve to the left

Equilibrium in the real sector and in the financial sector

i

Y

IS1 LM

Increase in exports

IS2

Y2

i1

Y1

IS shows what should the income be at every level of i.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 atevery 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.

In the real sector investment falls, Y decreases andsavings fall too. The new equilibrium is achieved atpoint Е2

Е2

Е1

Equilibrium in the real sector and in the financial sector

i

Y

IS

LM1

E1

MS increases

LM2

LM shows what the interest rate should be at every level of income. The increase in MS reduces the iat the same income level Y1.

Y1

At a lower interest rate, however, I increase and AE > Y. Inventories fall, Y rises, and S increase, as well.

At the same time MD increases and the interest rate rises.

Е2

The new equilibrium is set at Е2