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

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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: square6 In the goods market equilibrium, production equals demand for the good: Y=Z . This is the IS relation . square6 Recall Z=C(Y-T) + I + G . square6 Before, we let C(Y-T)=c 0 +c 1 (Y-T) . We will now make it a general function. square6 Equilibrium: Y=C(Y-T) + I + G . square6 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 square6 Before we assumed that investment ( I ) was fixed. square6 We will now model it more realistically: square6 Investment increases with the level of sales. square6 Investment decreases with the interest rate. square6 The simplification we made before by making investment independent of these variables was so we could focus on the relationship between consumption and demand. square6 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 square6 Thus, equilibrium in the goods market becomes: Y=C(Y-T) + I(Y,i) + G square6 Now, given i , demand in an increasing function of output: square6 increase in output barb2right increase in (disposable) income barb2right increase in consumption; square6 increase in output barb2right increase in investment. square6 Notice, in the goods market we take interest rate as given and study what happens to output . square6 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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10 Output, Y Demand, Z Y* Y IS Relation and Interest Rate What happens in goods market if interest rate increases?
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