Ch5.1 - CHAPTER 5 Goods and Financial Markets: The IS-LM...

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CHAPTER 5 Goods and Financial Markets: The IS-LM Model 1
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1. The Goods Market and the IS Relation 2
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1 Assumptions 1.1 Assumptions Recall Assumptions of Ch.3 1. Assume that all firms produce the same good. 2. Assume that firms are able and willing to produce any amount of output that is demanded without requiring any changes in prices. (This assumption is maintained until Ch. 6) . ssume that the economy is closed .e., 3. Assume that the economy is closed (i.e., X=IM=0). [This assumption is dropped in Ch 8] 3 18]
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ssumptions Assumptions 4. Assume that investment does not respond to the interest rate. [This assumption will be relaxed in Ch.5] 5. Assume that investment does not depend on output. [This assumption will be relaxed in Ch.5] 6. Assume that inventory investment which is a small part of GDP can be ignored. 4
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2The eterminants of Investment 1.2 The Determinants of Investment rom now on we drop the assumption that ± From now on, we drop the assumption that investment is exogenous vestment depends on ( the level of sales; ± Investment depends on (i) the level of sales; and (ii) the interest rate. s sales rise firms will increase their purchase ± As sales rise, firms will increase their purchase of equipment and will build new plants. s sales decrease firms will reduce their ± As sales decrease, firms will reduce their investment. 5
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he Determinants of vestment The Determinants of Investment s terest rate creases the cost of ± As interest rate increases, the cost of borrowing rises. Therefore, some firms will not urchase new equipment since the return from purchase new equipment since the return from
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This note was uploaded on 02/19/2011 for the course ECON 1021 taught by Professor Kokwanwai during the Fall '08 term at CUHK.

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Ch5.1 - CHAPTER 5 Goods and Financial Markets: The IS-LM...

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