14.02_lecture_11-12

# 14.02_lecture_11-12 - IS IS-LM Roadmap 1) MARKET I : GOODS...

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M IS IS-LM LM

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Roadmap 1) MARKET I : GOODS MARKET goods demand = C + I + G (+NX) = Y = goods supply (set by maximizing firms) IS curve 2) MARKET II : MONEY MARKET money demand = L d (Y, r + π e ) = M s /P = money supply (set by the Fed) M curve LM curve - M QUILIBRIUM = EQUILIBRIUM IN BOTH MARKETS I and II 2 IS LM EQUILIBRIUM EQUILIBRIUM IN BOTH MARKETS I and II
Goods Market IS curve represents the equilibrium in the goods market: ) =C+I+G+NX (1) Y = C + I + G + NX Recall the definition of private savings S (hh) = Y – T – C Recall the definition of national savings S = S (hh) + T – G Combining them (2) S±= ±Y±–C ±–G± From (1) and (2) the demand side of the economy can be written as: S = I + NX 3 The IS curve is named as it is because it documents the relationship between Investment and Saving (holding NX constant).

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Demand side : the IS curve C is a function of PVLR (Y, Y f , W), tax policy, expectations, etc. I is a function of r, A f , K, and investment tax policy. G is a function of government policy (we will discuss this shortly) NX we will model in the last lecture of the course (for the U.S., NX is small) The IS curve relates Y to r . How do interest rates affect Y? As r falls, Investment increases (due to firm profit maximization behavior). Also Consumption increases (substitution effect dominates) 4 IS curve is downward sloping in {r, Y} space .
IS Curve: Graphical Derivation I curve S curve (Y=Y 1 ) r r r* r* I,S Y Y 1 5

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IS Curve: Graphical Derivation I curve S curve (Y=Y 1 ) r IS r S curve (Y=Y 2 ) r 1 r 2 I,S Y n increase in current Y leads to more desired S Y 1 Y 2 6 An increase in current Y leads to more desired S, hence the equilibrium r needs to be lower!
IS curve r r* r* Y IS Y Suppose r is set by the Fed at the level of r* (we will explore this in depth later in the course). For a given r, we can solve for the level of output desired by the demand side of the economy. e represent the demand side of the economy drawn in {r Y} space as the I curve Why IS? 7 We represent the demand side of the economy, drawn in {r,Y} space as the I-S curve. Why IS? Because the demand side of the economy can be boiled down to I = S (when NX is zero)

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What shifts the IS curve What shifts the IS curve to the right? Anything that increases C, I or G (or NX when we model it): higher expected income or wealth higher PVLR higher C higher conusmer confidence higher PVLR higher C higher Tr or lower T (if the Ricardian equivalence fails) higher C igher expectations about f igher PK f igher higher expectations about A higher MPK higher I higher business confidence higher MPK f higher I lower δ or mm, or lower t K lower adjusted user cost of K higher I higher G Changes in r WILL NOT cause IS curve to shift 8 (causes movement along IS curve)
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## This note was uploaded on 10/25/2009 for the course 14 14.02 taught by Professor Geurrieri during the Fall '09 term at MIT.

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14.02_lecture_11-12 - IS IS-LM Roadmap 1) MARKET I : GOODS...

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