Review_of_IS_LM

# Review_of_IS_LM - Review of IS-LM curves and ED-ES curves...

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1 Review of IS-LM curves and ED-ES curves Grigorios Livanis IS and ED curves (equilibrium in the product market) ( ) Y C I G X M = + + + (1) where Y = GDP or Income C = Consumption G = Government Purchases X = Exports M = Imports Note that ( ) C C Y T = that is, consumption is a function of Income ( Y ) and Taxes ( T ). If taxes increase then consumption decreases. If income increases then consumption increases. ( ) ( ) e I I r I i π = = that is, Investment is a function of the real interest rate ( r ), and real interest rate is equal to the nominal interest rate ( i ) minus the expected inflation ( e π ). If the real interest rate increases then Investment decreases. Using the above we can rewrite equation (1) as: ( ) ( ) ( ) Y C Y T I r G X M = + + + (2) We will be using this equation to map changes in the IS and ED (economy demand) curves. For instance, An increase in taxes Æ consumption decreases Æ Y decreases Æ IS curve shifts to the left. Same for ED curve. An increase in government purchases Æ Y increases Æ IS curve shifts to the right. Same for ED curve. An increase in Investment Æ Y increases Æ IS curve shifts to the right. Same for ED curve. An increase in imports ( M ) Æ Y decreases Æ IS curve shifts to the left. Same for ED curve. LM curve (equilibrium in the money market) ( , ) M m Y r P = (3) where M P = real money supply ( , ) m Y r = money demand, that depends on Income ( Y ) and real interest rate ( r ). If income increases then demand for money increases ( m ), while if real interest rate increases then demand for money decreases ( m ) We will be using equation (3) to map changes in the LM curve. For instance, If money supply increases ( M P ) then LM curve shifts to the right (and ED to the right).

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