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8. islm model

8. islm model - The ISLM Model 7 October 2010 1 Reading...

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The IS—LM Model 7 October 2010 1 Reading Chapter 9 of Abel/Bernanke/Croushore 2 The IS Curve: Equilibrium in the Goods Mar- ket Equilibrium in the goods market in a closed economy entails, Y = C d + I d + G ; i.e., AS is just equal to AD. The condition can alternatively be stated as the equality of saving and investment, S d = I d . Given that S d and I d are increasing and decreasing in r, respectively, any initial discrepancy between S d and I d would be closed by the adjustment in r . The IS ( short for investment—saving ) curve is relationship between Y and r that satis fi es goods market equilibrium, or its equivalent, the saving—investment equilibrium. That is, the IS curve shows for each level of Y , the r that equates saving and investment. Think of an increase in Y , then S d increases for each r . Holding the demand for investment constant (because it should not be a ff ected by current output), the equilibrium between saving and investment must result in a lower interest rate. That is, the IS curve is downward sloping. Alternative interpretation in terms of goods market equilibrium: Beginning at a point of equilibrium, suppose the real interest rate rises. The increased real interest rate causes people to increase saving and thus reduce consumption, and causes fi rms to reduce investment. So the quantity of goods demanded declines. To restore equilibrium, the quantity of goods supplied would have to decline. So higher real interest rates are associated with lower output. 1

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Figure 1: Price and output determination in a single market Figure 2: Output and interest rate in the general equilibrium 2
Figure 3: The derivation of the IS curve Factors that shift the IS curve: Any change that reduces desired national saving at each interest rate shifts the IS curve up and to the right, such as for instance caused by a temporary increase in G . Imagine constant output, so a reduction in saving means desired investment exceeds saving; the interest rate must rise to close the excess demand for investment funds. Similarly, a change that increases desired national saving shifts the IS curve down and to the left. Alternatively, the shift of the IS curve may be described by changes in goods market equilibrium: A change that increases aggregate demand for goods shifts the IS curve up and to the right. This is the case since any excess demand for goods would cause the real interest rate to rise to reduce desired consumption and investment until equilibrium is restored. The IS curve shifts up and to the right because of an increase in expected future output an increase in wealth a temporary increase in government purchases 3

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Figure 4: How the IS curve may shift a decline in taxes (if Ricardian equivalence doesn’t hold) an increase in the expected future marginal product of capital a decrease in the e ff ective tax rate on capital 3 The LM Curve: Equilibrium in the Asset Mar- ket There are numerous asset markets — one for each asset, be it real or fi nancial.
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8. islm model - The ISLM Model 7 October 2010 1 Reading...

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