ECONOMICS
Lec 2 IS – LM.pptx

Lec 2 IS – LM.pptx - IS LM MODEL AND AGGREGATE DEMAND(AD...

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IS – LM MODEL AND AGGREGATE DEMAND (AD) IN CLOSE ECONOMY Lecture 2 Mentor: Pham Xuan Truong ([email protected])
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Back ground on the model The Great Depression caused many economists to question the validity of classical economic theory. They believed they needed a new model to explain such a pervasive economic downturn and to suggest that government policies might ease some of the economic hardship that society was experiencing. In 1936, John Maynard Keynes wrote The General Theory of Employment, Interest, and Money. In it, he proposed a new way to analyze the economy, which he presented as an alternative to the classical theory. Keynes proposed that low aggregate demand is responsible for the low income and high unemployment that characterize economic downturns. He criticized the notion that aggregate supply alone determines national income .
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Back ground on the model The model rests on two fundamental assumptions All prices (including wages) are fixed. There exists excess production capacity in the economy Why can there be insufficient demand ? Criticism of Say’s law: Uncertainty can lead to precautionary saving rather than consumption. Monetary criticism: the preference for liquidity can lead to under-investment as savings are kept in the form of liquidity.
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Back ground on the model Differences between “Keynesian” and Classical: + Velocity of money is variable and wages are fixed (Classical: velocity of money is constant and wages are highly flexible) + The level of demand determines the level of output and employment (Classical: level of production determines level of output and employment) + There can be an equilibrium level of involuntary unemployment (Classical: there is no involuntary unemployment at equilibrium level of economy) The model of aggregate demand (AD) can be split into two parts: IS model of the “goods market” and the LM model of the “money market.” “IS stands for Investment Saving, Whereas LM stands for Liquidity Money.”
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Back ground on the model The Keynesian model can be viewed as showing what causes the aggregate demand curve to shift. In the short run, when the price level is fixed, shifts in the aggregate demand curve lead to changes in national income, Y. The model of aggregate demand developed in this chapter called the IS- LM is the leading interpretation of Keynes’ work developed by Sir J.Hicks (nobel laureate). The IS-LM model takes the price level as given and shows what causes income to change. It shows what causes AD to shift.
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Content I The goods market and IS curve II The money market and LM curve III Equilibrium of IS – LM model and its implications IV Coordinate Fiscal policy and Monetary policy
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I The goods market and IS curve 1 The goods market (Keynesian cross – point model) Y APE (AE) APE=C+I+G Y=APE APE* Y* C = + MPC(Y – ) I = G = I, G, and T are assumed exogenous and fixed.
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