l05_eng - IS-LM MODEL GENERAL EQUILIBRIUM IN GOODS AND MONEY MARKETS Dongpeng Liu Department of Economics Nanjing University PARTIAL vs GENERAL

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IS-LM MODEL: GENERAL EQUILIBRIUM IN GOODS AND MONEY MARKETS Dongpeng Liu Department of Economics Nanjing University
PARTIAL vs. GENERAL EQUILIBRIUM Income expenditure model sheds light on goods market equilibrium In the last lecture, we discussed money market equilibrium Equilibrium in a single market is called partial equilibrium The economy as a whole is in equilibrium only when all markets are in equilibrium simultaneously ( general equilibrium ) General equilibrium model of goods and money markets: the IS-LM model MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 2
ROADMAP MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 3 INCOME EXPENDITURE LIQUIDITY PREFERENCE IS CURVE LM CURVE AGGREGATE DEMAND SHORT-RUN LABOR MARKET AGGREGATE SUPPLY AS-AD MODEL IS-LM MODEL PHILLIPS CURVE INTERMEDIATE-RUN SOLOW MODEL LONG-RUN w/ CAPITAL ACCUMULATION LONG-RUN AS-AD MODEL LONG-RUN w/o CAPITAL ACCUMULATION
GOODS MARKET AND THE IS RELATION IS relation: total output (or income) Y equals total expenditure Z ? = ? = 𝐶 ? − 𝑇 + 𝐼 + 𝐺 Investment is assumed to be exogenously given in the income expenditure model This assumption is not realistic Now, let’s relax it MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 4
INVESTMENT Total amount of investment hinges on interest rate 𝐼 = 𝐼 𝑖 𝐼 𝑖 is a decreasing function of 𝑖 Interest rate determines the cost of investment MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 5
INVESTMENT AND INTEREST RATE If a firm borrows money to finance its investment, higher interest rate raises borrowing cost, making the firm less willing to borrow and invest If the firm uses its own fund to invest, the opportunity cost includes the interest income that could have been earned from the funds. Higher interest rate raises the opportunity cost of investment and lowers firms’ willingness to invest MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 6
AN ALTERNATIVE PERSPECTIVE If we deposit \$1 today, we can withdraw \$(1+i) next year \$1 today is equivalent to \$(1+i) next year In other words, \$1 next year is equivalent to \$1/(1+i) today Future cash flow can be discounted to today’s value ( present value ) Interest rate and the present value of a future cash flow are negatively related MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 7
AN ALTERNATIVE PERSPECTIVE An investment is a tradeoff between current cash outflow and future cash inflows A firm shall only make an investment if the PV of all future cash flows is higher than the current cash outflow An increase in interest rate causes the PV of future cash flows to fall If the PV of all future cash flows falls below the current cash outflow, the investment will no longer make sense Therefore, the economy-wide total amount of investment and interest rate are negatively related MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 8
DETERMINATION OF OUTPUT Let’s recall the IS relation ? = ? = 𝐶 ? − 𝑇 + 𝐼(𝑖) + 𝐺