Chapter 5

Chapter 5 - Short Run: The IS-LM Model (Blanchard ch. 5)...

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Short Run: The IS-LM Model (Blanchard ch. 5) Prof. Irina A. Telyukova UCSD Econ 110A Spring 2008
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2 Outline We have now studied the goods market and the financial market in separation. Time to put them together, to study the whole economy. I. We revisit the goods market and derive the IS curve . II. We revisit the financial market and derive the LM curve . III. The economy as a whole is treated as an agglomeration of goods and financial markets: the IS-LM model . IV. We will talk about fiscal and monetary policy in this economy. V. We will also look at how well the model does in describing the U.S. economy.
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3 I. Goods Market: IS Relation Brief review of the goods market as we have seen it before: s In the goods market equilibrium, production equals demand for the good: Y=Z . This is the IS relation . s Recall Z=C(Y-T) + I + G . s Before, we let C(Y-T)=c 0 +c 1 (Y-T) . We will now make it a general function. s Equilibrium: Y=C(Y-T) + I + G . s There was no link between the interest rate and the goods market before, because of simplifications we made.
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4 Goods Market: Investment and the Interest Rate s Before we assumed that investment ( I ) was fixed. s We will now model it more realistically: s Investment increases with the level of sales. s Investment decreases with the interest rate. s The simplification we made before by making investment independent of these variables was so we could focus on the relationship between consumption and demand. s That relationship still holds. We simply add another layer of realism to our model. I I Y i = ( , ) ( , ) + −
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5 Goods Market: Expanded IS Relation s Thus, equilibrium in the goods market becomes: Y=C(Y-T) + I(Y,i) + G s Now, given i , demand in an increasing function of output: s increase in output b increase in (disposable) income b increase in consumption; s increase in output b increase in investment. s Notice, in the goods market we take interest rate as given and study what happens to output . s Bottom line: IS relation determines equilibrium output level in the goods market.
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6 IS Relation Output, Y Demand, Z
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7 Output, Y Demand, Z Y (Production) IS Relation
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8 Output, Y Demand, Z Y (Production) Z IS Relation
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9 Output, Y Demand, Z Y* Y (Production) Z IS Relation Goods market equilibrium
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This note was uploaded on 04/29/2008 for the course ECON 110A taught by Professor Staff during the Spring '08 term at UCSD.

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Chapter 5 - Short Run: The IS-LM Model (Blanchard ch. 5)...

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