Lecture_05_2007

Lecture_05_2007 - Determination of Output Keynesian IS­LM...

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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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This note was uploaded on 07/16/2011 for the course ECON 5327 taught by Professor Staff during the Spring '08 term at UT Arlington.

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