the keynesian cross model, the money market, and is/lm
DESCRIPTION
The Keynesian Cross Model, The Money Market, and IS/LM. Planned expenditure and actual expenditure. Constructing the Keynesian Cross. mpc. £ 1. Actual expenditure is Y and planned expenditure is E = C + I + G. I, G, and T are assumed exogenous and fixed. - PowerPoint PPT PresentationTRANSCRIPT
The Keynesian Cross Model, The
Money Market, and IS/LM
Planned expenditure and actual expenditure.
Constructing the Keynesian Cross
• Actual expenditure is Y and planned expenditure is E = C + I + G.
• I, G, and T are assumed exogenous and fixed.
• Our consumption function is C = c(Y–T), where c is the marginal propensity to consume (mpc).
• Mapping out E = c(Y–T) + I + G gives us… Y
E
E=C+I+G
Y=E
£1
mpc
Y*
E*
• The slope of E is the mpc.• In equilibrium planned
expenditure equals total expenditure or Y=E.
Constructing the Keynesian Cross
Y
E
E=C+I+G
Y=E
• Equilibrium is at the point where Y = C + I + G.
mpc
Y*
E*
Y2 Y1
Inventory accumulates.
Inventory drops.
£1
• Because actual expenditure exceeds planned expenditure, inventory accumulates, stimulating a reduction in production.
• Similarly at Y2, Y < E• Because planned expenditure
exceeds actual expenditure, inventory drops, stimulating an increase in production.
• If firms were producing at Y1 then Y > E
Government expenditure and tax multipliers
• An increase of G by ΔG causes an upward shift of planned expenditure by ΔG.
Y
E
ΔG
Y=E
Y1
E1
E2
• Notice that ΔY > ΔG. This is because although ΔG causes an initial change in Y of ΔG, the increased Y leads to an increase in consumption and triggers a multiplier effect.
• Now suppose a decrease of T by ΔT that causes an upward shift of planned expenditure by mpc*ΔT.
Y2
• Notice again that ΔY > ΔT but that ΔY is less than in the case with ΔG. This is because ΔT causes no initial change in Y as ΔG did, the decrease in T simply leads to an increase in consumption and triggers the multiplier effect.
Y3
E3
mpc*ΔT
Building the IS curve
• The IS curve maps the relationship between r and Y for the goods market.
IS
Y
E
Y2 Y1
r
I
I(r)
ΔI
Y2 Y1
r2
r1
r2
r1
I(r1)I(r2)
E=Y
E=C+I(r1)+G
E=C+I(r2)+GLet the interest rate increase from r1 to r2
reduce planned investment from I(r1) to I(r2).
This decrease in investment causes the planned expenditure
function to shift down.
So Y decreases from Y1 to Y2.
Y
r
The IS curve maps out this relationship between the
interest rate, r, and output (or income) Y.
Shifting the IS curve
• While changing r allows us to map out the IS curve, changes in G, T, or mpc cause Y to change for any level of r. This causes a shift in the IS curve.
IS
Y
E
Y1 Y2
ΔG
Y1 Y2
r1
E=Y
E=C+I+G2
E=C+I+G1
Suppose an increase in G causes planned
expenditure to shift up by ΔG.
Y
rFor any r the increase in G causes an increase in Y of ΔG times the government
expenditure multiplier.
Therefore, the IS curve shifts to the right by this
amount.
IS´
A loanable funds market interpretation
• The IS curve maps the relationship between r and Y for the loanable funds market in equilibrium.
IS
r
II(r)
Y2Y1
r2
r1r1
r2
S(Y2)
Y
rS(Y1)
• Suppose Y increases from Y1 to Y2. This raises savings from S(Y1) to S(Y2) resulting in a lower equilibrium interest rate.
• The IS curve maps out this relationship between the lower interest rate and increased income.
A loanable funds market interpretation of fiscal policy
• While changing r allows us to map out the IS curve, changes in G, T, or mpc cause Y to change for any level of r. This causes a shift in the IS curve.
IS
r
I
I(r)
Y1
r2
r1r1
S(G1)
Y
r
r2
S(G2)
IS´
• Suppose again an increase in G. In the loanable funds market this results in a decrease in S and an increase in the interest rate.
• Therefore, for a given Y there is a higher level of r. So, the IS curve shifts up by this amount.
Building the LM curve
• The LM curve maps the relationship between r and Y for the money market.
LM
r
Real Money Balances
L(r,Y2)
Y1
r2
r1r1
Given money supply and money demand
suppose an increase in income raises money
demand.
Y
r
r2
(M/P)s
L(r,Y1)
The LM curve maps out this relationship
between r and Y.
Y2
Shifting the LM curve
• While changing money demand allows us to map out the LM curve, changes in M or P cause r to change for any level of Y. This causes a shift in the LM curve.
r
Real Money Balances
r2
r1
Given money supply and money demand suppose a
decrease in the money stock shifts real money supply to the left resulting in a higher
equilibrium interest rate.
(M1/P)s
L(r,Y)
Now there is a higher real interest rate for the current
level of output.
(M2/P)s
The LM curve shifts up so that at the same
level of output the interest rate is higher.
LM
Y
r2
r1
Y
r
LM´
IS=LM: The Short Run Equilibrium
• Given our IS and LM equation we can now determine the short run equilibrium interest rate and output
LM
Y*
r*
Y
r
IS
• By mapping out the relationship between Y and r when the goods market (or loanable funds market) is in equilibrium we get the IS curve.
• By mapping out the relationship between Y and r when the money market is in equilibrium we get the LM curve.
• When we set IS=LM we can solve for the equilibrium levels of r and Y. This represents simultaneous equilibrium in the goods market (or loanable funds market) and the money market.
Conclusion
• We constructed the IS curve from the goods market and from the loanable funds market. We discussed shifting factors for IS.
• We constructed the LM curve from the money market and discussed shifting factors for LM.
• Finally, we set IS=LM to achieve equilibrium in all markets giving us short run equilibrium r and Y.