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Unformatted text preview: A-1 1 In a closed-economy context, the original exposition of the IS-LM model is in J. R. Hicks, Mr. Keynes and the Classics: A Suggested Interpretation, Econometrica 5 (April 1937), pp. 147159. Hickss article still makes enjoyable and instructive reading today. The name IS comes from the fact that in a closed economy (but not nec- essarily in an open economy!) the output market is in equilibrium when investment ( I ) and saving ( S ) are equal. Along the LM schedule, real money demand ( L ) equals the real money supply ( in our notation). The open- economy version of the model, with the expectations assumption made for simplicity, is called the Mundell-Fleming model . Columbia University economist Robert Mundell won a Nobel Prize in 1999 for his work on the model. E = E e M s / P Online Appendix A to chapter 16 The IS-LM Model and the DD-AA Model In this appendix we examine the relationship between the DD-AA model of the chapter and another model frequently used to answer questions in international macroeconomics, the IS- LM model. The IS-LM model generalizes the DD-AA model by allowing the real domestic interest rate to affect aggregate demand. The diagram usually used to analyze the IS-LM model has the nominal interest rate and output, rather than the nominal exchange rate and output, on its axes. Like the DD-AA dia- gram, the IS-LM diagram determines the short-run equilibrium of the economy as the inter- section of two individual market equilibrium curves, called IS and LM . The IS curve is the schedule of nominal interest rates and output levels at which the output and foreign exchange markets are in equilibrium, while the LM curve shows points at which the money market is in equilibrium. 1 The IS-LM model assumes that investment, and some forms of consumer purchases (such as purchases of autos and other durable goods), are negatively related to the expected real interest rate. When the expected real interest rate is low, firms find it profitable to borrow and undertake investment plans. (The appendix to Chapter 7 presented a model of this link between investment and the real interest rate.) A low expected real interest rate also makes it more profitable to carry inventories rather than alternative assets. For both these reasons, we would expect investment to rise when the expected real interest rate falls. Similarly, because consumers find borrowing cheap and saving unattractive when the real interest rate is low, interest-responsive consumer purchases also rise when the real interest rate falls. As Appen- dix 1 to Chapter 16 shows, however, theoretical arguments as well as the evidence suggest the consumption response to the interest rate is weaker than the investment response.the consumption response to the interest rate is weaker than the investment response....
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