Unformatted text preview: ISLM: 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  ISLM 2 ISLM: 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 ISLM: Grand Equil
The Changes in the Interest Rate does not shift IS or LM! (Y, i) are endogenous variables in the ISLM model. Only changes to variables exogenous to the ISLM
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  ISLM 5 Increase in T
Figure 57A The Effects of an Increase in Taxes (cont.) not equilibrium
need to consider
fianacial market ECON2123 L1  ISLM 6 Increase in T
Figure 57C The Effects of an Increase in Taxes Y and i decreases ECON2123 L1  ISLM 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 ISLM 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  ISLM 8 Help! Illustration
Figure 54 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  ISLM 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  ISLM 10 Increase in Ms – Monetary Expansion Do the reading please
Figure 58 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  ISLM 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(YT)+I(Y,i)+G
c0 is a constant, c1 is <1, so C(YT) increases by less than how much G increases> Y increases
C = co+c1(YT); I = b0+b1Yb2i
Y=c0+c1(YT(+b0+b`Yb2i+G
Y=[1/(1cab1)][c0c1T+b0b2i+G]
autonomous spending would increase
x 3) Thank you very much! See you next time ! ...
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 Fall '14
 Macroeconomics, Monetary Policy, Liquidity preference, lm curve, MD, Yao Amber Li

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