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Unformatted text preview: Determination of Output
Keynesian ISLM Model assumes price level is fixed
IS
Aggregate Demand
ad
Y = C + I + G + NX
NX
Equilibrium
ad
Y=Y
Consumption Function
C = a + (mpc × YD)
Investment
1. Fixed investment
2. Inventory investment
ad
Only planned investment is included in Y
1 Consumption
Function 2 Keynesian Cross Diagram Assume G = 0, NX = 0, T = 0
Yad = C + I = 200 + .5Y + 300 =
500 + .5Y
Equilibrium:
1. When Y > Y*, Iu > 0 ⇒ Y ↓ to
Y*
2. When Y < Y*, Iu < 0 ⇒ Y ↑ to
Y* 3 Expenditure Multiplier
Expenditure Analysis of Figure 3:
Analysis
Expenditure Multiplier
ΔI = 100 ⇒ ΔY = 200 ⇒ ΔY/ΔI = 200/100 = 2
1
Y = (a + I + G) ×
1 – mpc
A = a + I + G = autonomous spending
autonomous Conclusions:
Changes in any of the autonomous components, a, I,, or G will
Changes
I or
cause real output to change by a greater amount determined by
the simple expenditure multiplier:
1
1 – mpc The Great Depression
The
and the Collapse of Investment Role of Government
Role Analysis of Figure 5:
Analysis
Role of Government
ΔG = + 400, Δ T = + 400
d
1. With no G and T, Y = C + I = 500 + mpc × Y = 500 + .5Y, Y1 = 1000
mpc
2. With G, Y= C + I + G = 900 + .5Y, Y2 = 1800
d
3. With G and T, Y = 900 + mpc × Y – mpc × T = 700 + .5Y, Y3 = 1400
mpc
700 Conclusions:
1. G ↑ Y ↑; T ↑ Y ↓
2. ΔG = ΔT = + 400, Y ↑ 400
400, Role of International Trade
Role ΔNX = +100,
ΔY/ΔNX = 200/100 = 2
= 1/(1 – mpc) = 1/(1 – .5) Summary:
Summary:
Factors that
Affect Y IS
Curve
IS curve
1. i ↑ I ↓ NX ↓,
Yad ↓, Y ↓
Points 1, 2, 3 in
figure
2. Right of IS: Y >
Yad ⇒ Y ↓ to IS
Left of IS: Y <
Yad ⇒ Y ↑ to IS 11 ad Shift in
Shift
the IS
IS
Curve 1. C ↑: at given iA, Y ↑, Y
↑ ⇒ IS shifts right
2. Same reasoning when I
↑, G ↑, NX ↑, T ↓ How money affects the Economy
How
Early economists believed that output was determined
by the availability and price of the factors of
production; land, labor and capital.
If markets are perfectly competitive, then the resources
in the economy will be fully employed and output will
be at its fullemployment (i.e. fixed) level at all times.
Output is therefore determined by real factors (i.e. the
factors of production). Quantity Theory of Money
Velocity
P×Y
V=
M
Equation of Exchange
M×V=P×Y
Quantity Theory of Money
1. Irving Fisher’s view: V is fairly constant
2. Equation of exchange no longer identity
3. Nominal income, PY, determined by M
PY
4. Classicals assume Y is determined by real factors, not monetary
5. P determined by M
Quantity Theory of Money Demand
1
M=
× PY
PY
V
Md = k × PY Implication: interest rates not important to Md 14 Cambridge Approach
Cambridge
Is velocity constant?
1. Classicals thought V constant because
didn’t have good data
2. After Great Depression, economists
realized velocity far from constant Change in Velocity
Change
from Year to Year: 1915–2002 Keynes’s Liquidity Preference
Keynes
Theory
3 Motives
1. Transactions motive—related to Y
2. Precautionary motive—constant
3. Speculative motive
A. related to W and Y
B. negatively related to i
Liquidity Preference
Md
= f(i, Y)
P
–+ Keynes’s Liquidity Preference
Keynes
Theory
Implication: Velocity not constant P
1
d=
M
f(i,Y)
d Multiply both sides by Y and substitute in M = Md PY
Y
V=
=
M
f(i,Y)
1. i ↑, f(i,Y) ↓, V ↑
2. Change in expectations of future i or change f(i,Y) results
in a change in V Relation of Liquidity Preference
Relation
Framework to Loanable Funds
Keynes’s Major Assumption
Two Categories of Assets in Wealth
Money
Bonds
1. Thus:
2. Budget Constraint:
3. Therefore: Ms + Bs = Wealth
Bd + Md = Wealth
Ms + Bs = Bd + Md 4. Subtracting Md and Bs from both sides:
Ms – Md = Bd – Bs
Money Market Equilibrium
5. Occurs when Md = Ms
6. Then Md – Ms = 0 which implies that Bd – Bs = 0, so that Bd = Bs and bond
market is also in equilibrium Liquidity Preference Analysis
Liquidity
Derivation of Demand Curve
1. Keynes assumed money has i = 0
e
2. As i ↑, relative RET on money ↓ (equivalently, opportunity cost of money ↑)
RET
d
⇒M ↓
3. Demand curve for money has usual downward slope
Derivation of Supply curve
s
1. Assume that central bank controls M and it is a fixed amount
s
2. M curve is vertical line
Market Equilibrium
d
s
1. Occurs when M = M , at i* = 15%
s
d
2. If i = 25%, M > M (excess supply): Price of bonds ↑, i ↓ to i* = 15%
d
s
3. If i =5%, M > M (excess demand): Price of bonds ↓, i ↑ to i* = 15%
to Money
Money
Market
Equilibrium Rise in Income or the Price Level
Rise 1. Income ↑, Md ↑, Md
shifts out to right
s
2. M unchanged
3 i* rises from i1 to i2 Rise in Money Supply
Rise s s 1. Ms ↑, Ms shifts out
to right
d
2. M unchanged
3. i* falls from i to i
1
2 Factors
Factors
that Shift
Money
Demand
and
Supply
Curves LM Curve LM curve
1. Y ↑, Md ↑, i ↑ Points 1, 2, 3 in figure
2. Right of LM: excess Md, i ↑ to LM
Left of LM : excess Ms, i ↓ to LM 25 ISLM
ISLM
Model
Model
Point E, equilibrium
where Y = Yad (IS) and
Md = M s (LM )
At other points like A,
B, C, D, one of two
markets is not in
equilibrium and arrows
mark movement towards
point E Shift in the LM Curve from a Rise in Ms
Shift
LM 1. Ms ↑: at given YA, i ↓ in panel (b) and (a) ⇒ LM shifts to the right Shift in the LM Curve from a Rise in M
Shift
LM 1. M d ↑: at given YA, i ↑ in panel (b) and (a) ⇒ LM shifts to the left d s Response to an Increase in M
Response 1. M s ↑: i ↓, LM shifts
right ⇒ Y ↑ i ↓ Response to Expansionary Fiscal Policy
Response 1. G ↑ or T ↓: Yad ↑, IS
shifts right ⇒ Y ↑ i ↑ Summary:
Summary:
Factors
that Shift
IS and
IS LM
LM Curves Effectiveness
of Monetary
and Fiscal
Policy 1. M d is unrelated to i ⇒ i ↑, M d = M s at
same Y ⇒ LM vertical
2. Panel (a): G ↑, IS shifts right ⇒ i ↑, Y
stays same (complete crowding out)
3. Panel (b): M s ↑, Y↑ so M d ↑, LM shifts
right ⇒ i ↓ Y ↑
Conclusion: Less interest sensitive is M d,
more effective is monetary policy relative
to fiscal policy
32 ...
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This note was uploaded on 07/16/2011 for the course ECON 5319 taught by Professor Crowder during the Spring '11 term at UT Arlington.
 Spring '11
 CROWDER
 ISLM Model

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