Unformatted text preview: Determination of Output
Keynesian ISLM Model assumes price level is fixed
Aggregate Demand
Yad = C + I + G + NX
Equilibrium
Y = Yad
Consumption Function
C = a + (mpc × YD)
Investment
1. Fixed investment
2. Inventory investment
Only planned investment is included in Yad 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 Analysis of Figure 3: Expenditure Multiplier
∆ I = 100 ⇒ ∆ Y = 200 ⇒ ∆ Y/∆ I = 200/100 = 2
1
Y = (a + I + G) × 1 – mpc A = a + I + G = autonomous spending
Conclusions: Changes in any of the autonomous components, a, I, or G will cause real output to change by a greater amount determined by the simple expenditure multiplier: 1
1 – mpc
1 – The Great Depression and the Collapse of Investment Role of Government Analysis of Figure 5: Role of Government
∆ G = + 400, ∆ T = + 400
1. With no G and T, Yd = C + I = 500 + mpc × Y = 500 + .5Y, Y1 = 1000
2. With G, Y= C + I + G = 900 + .5Y, Y2 = 1800
3. With G and T, Yd = 900 + mpc × Y – mpc × T = 700 + .5Y, Y3 = 1400
T = 700 + .5
Conclusions:
1. G ↑ Y ↑; T ↑ Y ↓
2. ∆ G = ∆ T = + 400, Y ↑ 400 Role of International Trade ∆ NX = +100,
∆ Y/∆ NX = 200/100 = 2 = 1/(1 – mpc) = 1/(1 – .5) 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 ↓ IS to Left of IS: Y < Yad ⇒ Y ↑ to IS 11 1. C ↑: at given iA, Yad ↑, Y ↑ ⇒ IS shifts right
2. Same reasoning when I ↑, G ↑, NX ↑, T ↓ Shift in the IS Curve How money affects the Economy
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
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
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 from Year to Year: 1915–2002 Keynes’s Liquidity Preference 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 Theory Implication: Velocity not constant P 1 = Md f(i,Y) Multiply both sides by Y andsubstitute 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
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
Derivation of Demand Curve
1. Keynes assumed money has i = 0
e 2. As i ↑, relative RET on money ↓ (equivalently, opportunity cost of money ↑) 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 Market Equilibrium Rise in Income or the Price Level 1. Income ↑, Md ↑, Md shifts out to right
2. Ms unchanged
3 i* rises from i1 to i2 Rise in Money Supply 1. Ms ↑, Ms shifts out to right
2. Md unchanged
3. i* falls from i1 to i2
1 2 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 25 ISLM 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 1. Ms ↑: at given YA, i ↓ in panel (b) and (a) ⇒ LM shifts to the right d Shift in the LM Curve from a Rise in M 1. M d ↑: at given YA, i ↑ in panel (b) and (a) ⇒ LM shifts to the left s Response to an Increase in M 1. M s ↑: i ↓ LM shifts , right ⇒ Y ↑ i ↓ Response to Expansionary Fiscal Policy
1. G ↑ or T ↓ Yad ↑, IS : shifts right ⇒ Y ↑ i ↑ Summary
: Factors that Shift IS and 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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 Spring '08
 Staff
 Liquidity preference, lm curve, MD

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