# IS-LM Equilibrium for Both Goods& Financial Markets(cont...

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Unformatted text preview: IS-LM: Equilibrium for Both Goods & Financial Markets (cont.) Lecture 8 Oct 3, 2016 Announcements Assigned Reading: 5).Textbook, Chapter 5 When increstment is independent of the interest rate, IS curve would be a vertical line Why? The normal IS curve is downward sloping, because I (Y,i) when i increases, at same Y, I decreases -> demand Z decreases -> new equilbrium Y would be lower than Now, When i increases, at same Y, I constant -> demand Z constant -> new equilibrium Y would be same as before -> IS curve would be vertical An increase in the money supply must cause which of the following? 1. a leftward shift in the IS curve 2) a reduction in the interest rate and ambiguous effects on investment 3) an increase in investment and a rightward shift in the IS curve 4) no change in the interest rate if investment is indepdent of the interest rate 5) no change in output if investment is independent of the interest rate Ans: 5) x 2): reduction in interest rate correct, but 2nd part incorrect (y increases, I increases; i decreases, I increases -> I(Y,i) -> LM curve shifts to the right x 3) increase in investment but just shift LM curve ECON2123 L1 - IS-LM 2 IS-LM: Grand Equil IS curve is drawn for a given fiscal policy. Changes in fiscal policy that raise the demand for goods and services shift the IS curve to the right (shift out ). Changes in fiscal policy that reduce the demand for goods and services shift the IS curve to the left (shift in). LM curve is drawn for a given monetary policy. Changes in monetary policy that raise the money supply shift the LM curve down (or shift out ). Changes in monetary policy that reduce the money supply shift the LM curve up (shift in). Macroeconomics by Yao Amber LI 3 IS-LM: Grand Equil The Changes in the Interest Rate does not shift IS or LM! (Y, i) are endogenous variables in the IS-LM model. Only changes to variables exogenous to the IS-LM model can shift the IS or LM curve. For example, the changes in G or T (fiscal policy) or the changes in money supply (monetary policy). Macroeconomics by Yao Amber LI 4 Apps: Fiscal and Monetary policy Government chooses G and T Fiscal policy: G – T < = > 0 T affects IS or LM curve or both? IS only! How? Increase in T: IS shifts left (smaller Y at same i) Decrease in T: IS shifts right (bigger Y at same i) How about change in G? Monetary Policy: Central Bank chooses Ms Ms affects IS or LM curve or both? LM only! only affects money supply ECON2123 L1 - IS-LM 5 Increase in T Figure 5-7A The Effects of an Increase in Taxes (cont.) not equilibrium need to consider fianacial market ECON2123 L1 - IS-LM 6 Increase in T Figure 5-7C The Effects of an Increase in Taxes Y and i decreases ECON2123 L1 - IS-LM 7 Increase in T Decrease in Y and i How about Md? Md curve shift down: Y decreases satisfies equilibrium in financial market: reduction in output and interest rate New IS-LM equilibrium: “Move along” LM curve!!! How about Demand (Goods market)? Point “D” (see previous slide) represents an equilibrium for Good Market! However, not equilibrium for Financial Market Question: At “D”, regarding LM, Ms < > Md? Financial Market therefore “imposes” a downward pressure on i !!! Eventually, reaches A’ ECON2123 L1 - IS-LM 8 Help! Illustration Figure 5-4 The Derivation of the LM Curve Area above LM: Md < Ms given that money supply is constant . Md<Ms X ? Md=Ms i increase, L decrease ECON2123 L1 - IS-LM 9 Increase in T – effect on C and I From point A to point D: T increase leads to decrease in disposable income, so Demand decreases: As C decreases Further decreases in Y reduces Demand further (Y level at point D: even less than Y’) Not only C decreases but also I decreases due to reduction in Y Decrease in i (from i to i’) will increase I, but eventually Demand (C + I) decreases (Y’) reduction in i increases I C for sure decreases Investment (I) unknown: Y ↓ , i ↓ I ? A better balance sheet of government may or may not increase I (fiscal contraction: good or bad?) ECON2123 L1 - IS-LM 10 Increase in Ms – Monetary Expansion Do the reading please Figure 5-8 The Effects of a Monetary Expansion M ↑ Y ↑, i ↓ I ↑ A monetary expansion is more investment friendly, i.e., increasing investment. not affected by money supply ECON2123 L1 - IS-LM 11 If government spending and taxes increase by the same amount, the IS curve would 1) shift to the right 2) shift to the left 3) not shift 4) none of the above Ans:1). IS relation: Y=C(Y-T)+I(Y,i)+G c0 is a constant, c1 is <1, so C(Y-T) increases by less than how much G increases-> Y increases C = co+c1(Y-T); I = b0+b1Y-b2i Y=c0+c1(Y-T(+b0+b`Y-b2i+G Y=[1/(1-ca-b1)][c0-c1T+b0-b2i+G] autonomous spending would increase x 3) Thank you very much! See you next time ! ...
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