ECO
ISLMnotes

# ISLMnotes - Olivier Coibion The IS-LM Model and Aggregate...

• Notes
• 19

This preview shows pages 1–3. Sign up to view the full content.

Olivier Coibion The IS-LM Model and Aggregate Demand These notes will construct our model of aggregate demand. This will be the standard “IS-LM” approach to aggregate demand, based on Keynes and Hicks. Essentially, we will describe two important macroeconomic markets: the market for savings and the market for money holdings. We will consider each market independently, taking the level of output as exogenous in each market but solving for the equilibrium interest rate in each market. We will then combine the two markets, using the IS-LM approach, to determine the equilibrium level of output and interest rates that ensure that both markets clear. Part 1: The Savings (Loanable Funds) Market This is the market for savings and investment. We will examine what the supply and demand for savings are, as well as to characterize how the price of savings (the real interest rate) is determined. The supply of savings Total saving in the economy can be divided into two components: public and private saving. Private saving S p is the saving done by consumers and is equal to after-tax income minus consumption: S p =Y-T-C. Public saving S g is the difference between tax revenues and government expenditures S g = T-G. Total saving S is the sum of public and private saving, and so S=S p +S g =(Y-T-C)+(T-G)=Y-C-G. Note that it appears that total savings does not directly depend on taxes. However, to the extent that changes in taxes can affect consumption or output, total saving will in general change with exogenous changes in taxes. Recall from our work on consumption that aggregate consumption could be described by a function of current after-tax income, consumer sentiment (as a proxy for permanent income), and the interest rate: C=C(Y-T,CS,r) . Hence, plugging this into our expression for total saving, we get S=Y-C(Y-T,CS,r)-G .

This preview has intentionally blurred sections. Sign up to view the full version.

Recall that consumption is increasing in after-tax income Y-T and consumer sentiment CS but decreasing in the real interest rate r . Hence, aggregate savings must be increasing in r but decreasing in CS . How does an increase in Y affect savings? An increase in Y has a direct positive effect on saving (since it is on the RHS of the expression above) but it also increases consumption which tends to decrease savings. We will refer to the increase in consumption from a 1\$ change in after-tax income the marginal propensity to consume ( mpc ). Suppose the mpc is 0.8, then if income goes up by a dollar, consumers will tend to raise their consumption by \$0.80. From the permanent income hypothesis, we know that transitory changes in income have small (less than one-for-one) effects on consumption, which tells us that as long as the change in Y is not permanent, then it must be that 0<mpc<1 . Consumption rises when income rises but by less than one-for one. Therefore, when Y goes up by a dollar, consumption goes up by less than a dollar, which means that total savings must rise. The amount by which savings rises is known as the marginal propensity to save ( mps ). Since income is either consumed or saved, it must be that mps=1-mpc .
This is the end of the preview. Sign up to access the rest of the document.
• Fall '13

{[ snackBarMessage ]}

### What students are saying

• As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

Kiran Temple University Fox School of Business ‘17, Course Hero Intern

• I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

Dana University of Pennsylvania ‘17, Course Hero Intern

• The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

Jill Tulane University ‘16, Course Hero Intern