ECON205 - Lecture 4 - The IS-LM model ECON205 Macroeconomic...

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The IS-LM model ECON205, Macroeconomic Theory and Policy - Lecture 4: Short Run Macroeconomics (III) Dr. Simone Marsiglio [email protected] Simone Marsiglio Macroeconomic Theory and Policy - Lecture 4 1 / 33
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The IS-LM model Outline Goods and financial markets together: IS-LM model Joint equilibrium: determining output and interest rate Fiscal and monetary policy: effects on output and interest rate Policy mix: combinations of fiscal and monetary policy Reading: Blanchard and Sheen (2013) Chapter 5 Simone Marsiglio Macroeconomic Theory and Policy - Lecture 4 2 / 33
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The IS-LM model Equilibrium output and interest rate Effects of monetary and fiscal policy Joint equilibrium in goods and financial markets: Determination of equilibrium income and interest rate IS-LM model: core of short run macroeconomics Effects of exogenous shocks: business fluctuations Effects of macroeconomic policy: contrasting business fluctua- tions Structure: mutual interactions between goods and financial markets (output and interest rate) Fiscal policy affecting goods market: through income on finan- cial markets Monetary policy affecting financial markets: through interest rates on goods market Simone Marsiglio Macroeconomic Theory and Policy - Lecture 4 3 / 33
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The IS-LM model Equilibrium output and interest rate Effects of monetary and fiscal policy Goods market equilibrium: production equal to demand for goods, Y = C ( Y - T ) + I + G Exogenous investment, I = I : output determination completely independent from interest rate Endogenizing investment: relation with output and interest rate Investment: two important determinants Sales level: investment needed to produce more (buying ma- chines or building plants) No inventory investment: sales and production coinciding Opportunity cost of investment: interest rate Assumptions: same interest rate for all firms; no difference between nominal and real interest rate (price level constant) Simone Marsiglio Macroeconomic Theory and Policy - Lecture 4 4 / 33
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The IS-LM model Equilibrium output and interest rate Effects of monetary and fiscal policy Investment function: I = I ( Y + , i - ) Income determining consumption: affecting firms’ level of sales and investment decision Goods market equilibrium: Y = C ( Y - T ) + I ( Y , i ) + G IS relation: combinations of income and interest rate clearing goods market Demand for goods increasing with output: two channels Higher output increasing disposable income and consumption: exogenous investment Higher output increasing investment: endogenous investment Simone Marsiglio Macroeconomic Theory and Policy - Lecture 4 5 / 33
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The IS-LM model Equilibrium output and interest rate Effects of monetary and fiscal policy Consumption and investment relations: linear functions Demand curve flatter than 45-degree line: increases in output leading to less than one-for-one increases in demand Sum of propensity to consume and to invest smaller than one: not obvious Empirical evidence: increase in output leading to less than pro- portional increase in demand Graphically: upward sloping demand (straight line)
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