Short Run: The IS-LM Model(Blanchard ch. 5)Prof. Irina A. TelyukovaUCSD Econ 110ASpring 2008
2OutlineWe have now studied the goods market and the financial market inseparation. 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.
3I. Goods Market: IS RelationBrief review of the goods market as we have seen it before:square6In the goods market equilibrium, production equals demand for the good: Y=Z. This is the IS relation.square6Recall Z=C(Y-T) + I + G. square6Before, we let C(Y-T)=c0+c1(Y-T). We will now make it a general function.square6Equilibrium: Y=C(Y-T) + I + G.square6There was no link between the interest rate and the goods market before, because of simplifications we made.
4Goods Market: Investment and the Interest Ratesquare6Before we assumed that investment (I ) was fixed.square6We will now model it more realistically: square6Investment increases with the level of sales.square6Investment decreases with the interest rate.square6The simplification we made before by making investment independent of these variables was so we could focus on the relationship between consumption and demand. square6That relationship still holds. We simply add another layer of realism to our model.II Y i=( , )( , )+ −
5Goods Market: Expanded IS Relationsquare6Thus, equilibrium in the goods market becomes:Y=C(Y-T) + I(Y,i) + Gsquare6Now, given i, demand in an increasing function of output:square6increase in output barb2rightincrease in (disposable) income barb2rightincrease in consumption;square6increase in output barb2rightincrease in investment.square6Notice, in the goods market we take interest rate as given and study what happens to output.square6Bottom line: IS relation determines equilibrium output level in the goods market.