Lecture 8 The IS - LM Model for Closed Economy.ppt

Lecture 8 The IS - LM Model for Closed Economy.ppt -...

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Unformatted text preview: Lecture 8: The IS-LM Model for Closed Economy Demand for Goods and Services Consumption Investment Firms and households purchase investment goods. Firms buy investment goods to add to their stock of capital. Households buy new houses The quantity of investment goods depends on the interest rate, which measures the cost of the fund used to finance investment. For investment project to be profitable, its return must exceeds its cost (the payment for borrowed funds). If interest rate rises, fewer investment projects are profitable, and the quantity of investment goods demanded falls. Investment Investment Real interest rate Quantity of Investment, I Government Purchases Equilibrium in the Market for Goods and Services IS-LM Model: The Model of Aggregate Demand The Goods Market and the IS curve IS curve plots the relationship between the interest rate and the level of income that arises in the market for goods and services. Y=C+I+G IS The theory of Liquidity Preferences Supply The theory of Liquidity Preferences Supply The theory of Liquidity Preferences The theory of Liquidity Preferences Money Demand and interest rate When interest rate is low, people hold most of their wealth in the form of money. When interest rate is high, the cost of holding money is high, so people hold less of their wealth in money and more in bonds that pay higher interest. Money demand varies inversely with the market interest rate. Supply The theory of Liquidity Preferences Whenever money market is not in equilibrium, people try to adjust their portfolio of assets and in the process alter the interest rate. Consider the interest rate is above the equilibrium level B vs A, the quantity of real money demanded exceeds the quantity supplied. Supply A fall in money supply The theory of Liquidity Preferences Banks and bond issuers, respond to the shortage supply of money by increasing the interest rates they offer. Supply A fall in money supply The theory of Liquidity Preferences If interest rate is below the equilibrium level, quantity of money demanded exceeds quantity supplied. Individuals try to obtain money by selling bonds or making bank withdrawals. To attract now scarcer funds, banks and bond issuers responds by increasing the interest rates they offer. Supply A fall in money supply The theory of Liquidity Preferences Eventually, the interest rate reaches the equilibrium level, at which people are content with their portfolio of monetary and non monetary assets. Supply A fall in money supply Income, Money Demand, and the LM Curve Income, Money Demand, and the LM Curve How monetary Policy shifts the LM Curve The Money Market and the LM curve LM curve plots the relationship between the interest rate and the level of income that arises in the market for money balances. Each point on the LM curve represents equilibrium in the money market. LM Short-Run Equilibrium LM IS Applying the IS-LM Model The IS-LM model can be used to understand Short-Run fluctuations. The IS curve represents the equilibrium in the market for goods and services The LM curve represents the equilibrium in the market for real money demand Learning Objectives: How changes in government purchases, taxes and the money supply influence the interest rate and national income for a given price level. Different shocks to the goods markets (IS curve) and the money market (LM curve) affect the interest rate and national income in the short run. Explaining Fluctuations with the IS-LM Model The intersection of the IS curve and the LM curve determines the level of national income. When one of the curves shifts, the short-run equilibrium of the economy changes, and national income fluctuates. Fiscal Policy Shifts the IS Curve Fiscal Policy Shifts the IS Curve Monetary Policy Shifts the LM Curve Monetary Policy Shifts the LM Curve Shocks in the IS-LM Model The IS-LM model shows how national income is determined in the short run, we can use the model to examine how various economic disturbance affect income. Shocks to the IS curves Shocks to the LM curves Shocks to the IS Curves Shocks to the IS curves arises from exogenous changes in the demand for goods and services. Firms become pessimistic about the future of the economy and this pessimism causes them to build fewer new factories. The fall in investment reduces planned expenditure and shifts the IS curve to the left. This reduces income and employment. Shocks to the IS curves arises from exogenous changes in the demand for consumer goods. Suppose a popular president is elected and this increases consumer confidence in the economy. This induces consumer to save less for the future and consume more today. This increases consumption increases planned expenditure and shifts the IS curve to the right This increases income and employment. Shocks to the LM Curves Shocks to the LM curves arises from exogenous changes in the demand for money. There is new restrictions on credit-card availability. This increases the amount of money people choose to hold. According to the theory of liquidity preference, when money demand rises, the interest rate necessary to equilibrate the money market is higher.. Hence, increase in money demand shifts the LM curve upward. This tends to raise the interest rate and depress income. In summary, different events can cause economic fluctuations by shifting the IS or LM curve. Policymakers can try to use the tools of monetary and fiscal policy to offset exogenous shocks. If policymakers are sufficiently quick and skilful, shocks to the IS and LM curves need not lead to fluctuations in income or employment. ...
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