ECO3200 Chap 11

Introduction

• Money plays a central role in the determination of income and employment

  • Interest rates are a significant determinant of aggregate spending => Fed controls the money supply in the U.S

• Interest rates

  • High before recession

  • Drop during recession

  • Rise during recovery

• Strong link between money and output

• IS-LM model is the core of short-run macroeconomics

  • Maintains the details of earlier model, but adds the interest rate as an additional determinant of AD

  • Includes the goods make and the money market, and their link through interest rates and income

Structure of IS-LM model

The Goods market and IS curve

• The IS curve shows combinations of interest rates and levels of output such that planned spending equals income

• Derived in 2 steps

  • Link between interest rate and investment

  • Link between investment demand and AD

• Investment is dependent upon interest rates (endogenous)

• The higher interest rates, the lower the investment demand

  • Interest rates are the cost of borrowing money

  • Increase interest rates raise the price to firms of borrowing for capital equipment => reduce the quantity of investment demand

Investment and the interest rate

• The investment sending function can be specified as I=Ibar-bi where b>0

  • i=interest rate

  • B= the responsiveness of investment spending to the interest rate

  • Ibar = autonomous investment spending

  • I= investment

• Negative slope reflects assumption that a reduction in i increases the quantity of I

• The position of the I schedule is determined by

  • The slope, b

  • Level of autonomous spending

The interest rate and AD: the IS curve

• Need to modify the AD function of the last chapter to reflect the new planned investment spending schedule

• Why an increase in i reduce AD for a given level of income and also reduce equilibrium output?

  • C is the total consumption.

  • C bar is the autonomous consumption, which is the amount of consumption that is not directly related to changes in income. It includes essential expenditures that individuals make even when they have no income.

  • c is the marginal propensity to consume, representing the percentage of additional income that people will spend on consumption.

  • TR bar: is the autonomous level of transfers, which are transfers that individuals receive regardless of their level of current income. These transfers are considered autonomous because they are not directly tied to the level of income. Ex: some education grand government give is not related to your income.

  • An increase in i reduces AD for given income and reduces equilibrium out put

    • Y=AD=Abar+c(1-t)Y-bi

    • i increase => AD reduce => AD shift left => Eqm output decrease

  • Answer: a change in i will change the equilibrium

• For given interest rate, i1 can draw the AD function with an intercept of Abar-bi1

• Figure shows negative relationship between i and Y => downward sloping IS curve

The position of the IS curve

• Figure shows 2 different IS curves => differ by levels f autonomous spending

• Bar denotes autonmous spening

• The change in income as result from change in autonomous spending (Abar) is deltaY=a_gdelata Abar

The slope of the IS curve

• The slteepness of the IS curve depends one

  • How sensitive investment spending is to change in i

  • The multiplier a_g

• Suppose investment spending is very sensitive to i

  • Given change in i produces large change in AD (large shift)

  • Large shift in AD produces large change in Y

  • Large change in Y resulting from given change in i => IS curve is relatively flat

• If investment spending is not very sensitive to i, the IS curve is relatively steep

Money Market and LM curve

• The LM curve shows combos f interest rates and levels of output uch that money demand equals money supply=> equilibrium in the money market

Demand for money

• Demand for money is demand for real money balances

  • People concerned with how much their money can buy, rather than number dollars in pocket

• Demand do real balances depends on

  • Real income: people hold money to pay for their purchases, which, in turn, depend on income

  • Interest rate: the cost of holding money

• The demand for money is: L=kY-hi

• The parameters k and h reflect the sensitivity of demand for real balances to the level of Y and i

• The demand function or real balances implies that for given level of income the quantity demanded is decreasing function of i

• Figure shows inverse relationship between money demand and i => money demand curve

The supply of money, money market equilibrium, and LM curve

• Nominal quantity of money supplied, M, controlled by central bank (real money supply is Mbar/Pbar) where M and Pare assumed fixed

• Starting at Y₁, the corresponding demand curve for real balances is L₁ => shown in panel a

  • Point E₁ is the equilibrium point in the money market

• Point E₁ is recorded in panel b as a point on the money market equilibrium schedule, or the LM curve

  • (i_1, Y₁) pair is a point on LM curve

• If income increases to Y2, real money balances higher at every level of I => money demand shifts to L2

  • Interest rate increases to i2 to maintain equilibrium in money market and new equilibrium is at point E2

• Record E2 in panel b as another point on the LM curve

  • Pair (i2, Y2) is higher up the given LM curve

• The LM schedule shows all combinations of interest rates and levels of income such that the demand for real balances is equal to the supply => money market is in equilibrium

• For the money market to be in equilibrium, supply must equal demand: Mbar/Pbar=kY-hi

• Solving for i: i=1/h(kY-Mbar/Pbar)

• The steeper the LM curve:

  • The greater the responsiveness of the demand for money to income, as measured by k

  • The lower the responsiveness of the demand for money to the interest rate h

• A given change in income has a larger effect on I, the larger is k and the smaller is h

The position of the LM curve

• Real money supply constant along. The LM curve => a change in the real money supply will shift the LM curve

• Figure shows effect of an increase in money supply

  • Equilibrium occurs at point E1 with interest rate i₁ => corresponding point E₁ on the LM curve

• If real money balances increases, money supply curve shifts to right

  • Restore equilibrium at income level Y1, the i must decrease too

  • In panel b the LM curve shifts down and right

Equilibrium and Goods/Money market

• The IS and Lm schedules summarized the conditions that have to be satisfied for the goods and money markets to the in equilibrium

• Assumptions:

  • Price level is constant

  • Firms willing to supply whatever amount of output is demanded at price level

• Equilibrium levels of income and internet rate change when either the IS or LM curve shifts