Intermediate Macroeconomics Ch5 notes

# Intermediate Macroeconomics Ch5 notes - Chapter 5 Goods...

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Chapter 5: Goods and Financial Markets: The IS-LM Model The Goods Market and the IS Relation The equilibrium condition in the goods market suggests that production Y be equal to the demand for goods Z. Then total investment I equals the sum of private and public savings, which represents the IS relation. Y = Z = C ( Y- T ) + Ī + G Suppose investment Ī is not an autonomous factor, but depends on production, Y, positively and interest rate, i, negatively. I = I(Y, i) ( +, -) after substitution, Y = C ( Y- T ) + I ( Y, i ) + G, which suggests that production must be equal to the demand for goods and it represent the IS relation. It also indicates that Y↑→YD↑→C↑ and Y↑→I↑. The relation between demand and output for a given interest rate is upward-sloping due to the positive relation between these two factors. Given the demand function ZZ = C ( Y- T ) + I ( Y, i ) + G, an increase in interest rate, which leads to a reduction in investment and production, tends to shift the demand function downward and vice-versa. When demand drops, it meets a lower output level at the new equilibrium. Then a higher interest rate corresponds to a lower investment level, a lower demand level, then a lower output level. The IS function, which indicates the relation between interest rate and output level, is downward sloping. The IS Function The IS curve implies equilibrium in the goods market at which production equals demand. It gives the equilibrium level of output as a function of interest rate. Changes in factors that decrease the demand for goods, such as an increase in taxes, T, or a drop in government expenditure, G, or a reduction in consumption, C, or exports, X, given the interest rate, shits the IS curve to the left and vice-versa. Financial Market and the LM Relation Recall the identity of M = \$Y L(i), where M is the nominal money stock, \$Y is nominal income and i is interest rate. Equilibrium in the financial market requires the money supply equals the money demand. After dividing price level, P, from both side,

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## This note was uploaded on 04/05/2009 for the course ECIF ECIF200 taught by Professor Henry during the Spring '09 term at University of Manchester.

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Intermediate Macroeconomics Ch5 notes - Chapter 5 Goods...

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