monetary macroeconomics lecture 3monetary macroeconomics lecture 3 aggregate demand: investment and...
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slide 1
Diploma Macro Paper 2
Monetary Macroeconomics
Lecture 3
Aggregate demand:
Investment and the IS-LM model
Mark Hayes
slide 2
Outline
Introduction
Map of the AD-AS model
This lecture, continue explaining the AD curve
Last time, Step 1: Equilibrium with variable income and consumption – the Keynesian Cross
Step 2: Equilibrium with variable income, consumption and investment – the IS-LM model
This lecture highly theoretical, we look at the data with the help of the model next time
Goods market
KX and IS
(Y, C, I)
Money
market (LM)
(i, Y)
IS-LM
(i, Y, C, I)
AD
Labour market
(P, Y)
AS
AD-AS
(P, i, Y, C, I)
Phillips Curve
(,u)
Foreign exchange
market
(NX, e)
AD*-AS
(P, e, Y, C, NX)
Exogenous: M, G, T, i*, πe
IS*-LM*
(e, Y, C, NX)
AD*
Goods market
KX and IS
(Y, C, I)
Money
market (LM)
(i, Y)
IS-LM
(i, Y, C, I)
AD
Labour market
(P, Y)
AS
AD-AS
(P, i, Y, C, I)
Phillips Curve
(,u)
Foreign exchange
market
(NX, e)
AD*-AS
(P, e, Y, C, NX)
Exogenous: M, G, T, πe
IS*-LM*
(e, Y, C, NX)
AD*
slide 5
The IS curve
Definition: a graph of all pairs of i and Y that result
in goods market equilibrium
i.e. value of output Y = expected expenditure E
Expected consumption C is an increasing function of income Y, as in the Keynesian Cross
PLUS: Expected investment I is now a decreasing
function of the money rate of interest i
The equation for the IS curve is:
slide 6
Money and real interest rates
Mankiw uses r to mean both nominal (money) and real interest rates. This confuses the Classical and Keynesian models.
In a monetary model, only the money rate (i) exists
as a causal variable.
The real interest rate only exists in a corn model.
What does exist in a monetary model is the
expected rate of inflation e. This is exogenous here.
Investment depends on i - e
For clarity always use i in a monetary model
slide 7
A note on curve shifting
A curve (or line) in a diagram is a relationship between two endogenous variables
Movement along the curve shows how one variable changes if the other does
We are mainly interested in comparing equilibrium positions, how the point of intersection moves
A change in an exogenous variable shifts a curve, which moves the equilibrium position
Movement along a curve only happens in disequilibrium and may not be realistic
slide 8
The investment demand curve
i
I
I (i)
Spending on
investment goods
is a downward-
sloping function of
the interest rate
slide 10
Y2 Y1
Y2 Y1
Deriving the IS curve
i I
Y
E
i
Y
E =C +I (i1 )+G
E =C +I (i2 )+G
i1
i2
E =Y
IS
I E
Y
slide 11
Y2 Y1
Y2 Y1
Shifting the IS curve: G
At any value of i,
G E Y
Y
E
i
Y
E =C +I (i1 )+G1
E =C +I (i1 )+G2
i1
E =Y
IS1
The horizontal
distance of the
IS shift equals
IS2
…so the IS curve
shifts to the right.
1
1 MPC
Y G Y
slide 12
Shifting the IS curve: T
Y2
Y2
At any value of i, T C E E =C2 +I (i1 )+G
IS2
The horizontal
distance of the
IS shift equals
Y
E
i
Y
E =Y
Y1
Y1
E =C1 +I (i1 )+G
i1
IS1
…so the IS curve
shifts to the left.
MPC
1 MPCY T Y
slide 13
The short-run equilibrium: IS-LM
Y
i
IS
LM
Equilibrium
interest
rate
Equilibrium
level of
income
slide 14
The money market
What determines the money interest rate?
NOT the supply and demand for loanable funds!
In the monetary model, the interest rate clears the money market, matching the supply and demand for a stock of money
In the Classical model, the interest rate clears the loanable funds market, matching the supply and demand for flows of saving for investment
Oil and water!
slide 15
Money supply
The supply of real money balances is fixed:
s
M P M P
M/P real money
balances
s
M P
M P
slide 17
Money demand (holding Y constant)
Demand for real money balances:
M/P real money
balances
s
M P
M P
slide 18
Equilibrium (holding Y constant)
The interest rate adjusts to equate the supply and demand for money:
M/P real money
balances
s
M P
M P
slide 19
Central Bank can raise the interest rate
To increase
,
CB reduces M
M/P real money
balances
interest
rate
1M
P
1
2
2M
P
slide 20
The LM curve
The LM curve is a graph of all combinations of
i and Y that equate the supply and demand
for real money balances.
The equation for the LM curve is:
slide 21
Deriving the LM curve
M/P
i
1M
P
L (i , Y1 )
i1
i2
i
Y Y1
i1
L (i , Y2 )
i2
Y2
LM
(a) The market for
real money balances (b) The LM curve
slide 22
How M <0 shifts the LM curve
M/P
i
1M
P
L (i , Y1 ) i1
i2
i
Y Y1
i1
i2
LM1
(a) The market for
real money balances (b) The LM curve
2M
P
LM2
slide 23
The short-run equilibrium: IS-LM
The short-run equilibrium is
the combination of i and Y
that simultaneously satisfies
the equilibrium conditions in
the goods & money markets:
Y
i
IS
LM
Equilibrium
interest
rate
Equilibrium
level of
income
(IS)
(LM)
slide 24
Y1 Y2
Deriving the AD curve
Y
i
Y
P
IS
LM(P1)
LM(P2)
AD
P1
P2
Y2 Y1
i2
i1
Intuition for slope
of AD curve:
P (M/P )
LM shifts left
i
I
Y
slide 25
Summary
We have derived the AD curve as a set of pairs of P and Y consistent with simultaneous equilibrium in the goods and money markets
The building blocks of the AD curve are the Keynesian Cross and the IS-LM model
We now have four endogenous variables:
Y, C, I and i
Exogenous variables include P, M, G and T