ISLMcomplete

ISLMcomplete - 10/27/2010 1 The complete ISLM model Juan...

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Unformatted text preview: 10/27/2010 1 The complete ISLM model Juan Carlos Cordoba ISU October 2010 Economic Fluctuations Equilibrium in Asset Markets The LM Curve y Equilibrium in asset markets requires: N + = , t t t s t r Y L P M y The ISLM model assumes that in the short term P t is fixed and that P t+1 only responds slowly to changes in aggregate conditions. y Therefore, t =(P t+1-P t )/P t is mostly fixed y Furthermore, M t s is assumed to be controlled by the monetary authority (in other words, M t s is exogenous). y Under these assumptions the equation above describes a relationship between output (Y ) and real interest rates (r ). + ) ( ) ( t P t t y This relationship is positive y A higher output ( Y) would increase real money demand, L. y To restore the equilibrium in asset markets, the real interest rate (r) should increase: r should increase to reduces L to its original level. 10/27/2010 2 Asset Market Equilibrium The LM Curve LM curve: (r,Y) combinations such that asset markets are in equilibrium. M s /P r r r r L(Y 1 ,r+ ) r 1 r 1 LM curve M s /P Equilibrium pair Equilibrium pair M/P Y L(Y ,r+ ) Y Y 1 Money Supply Increase and the LM Curve M s M s 1 r r r r r 1 LM LM 1 P P 1 Asset Market Equilibrium M/P Y L(Y ,r+ ) Y 1 r 1 The LM Curve 10/27/2010 3 Price Reduction ( P 1 <P ) and LM Curve M s M s r r r r r 1 LM LM 1 P 1 P Equilibrium in Asset Markets M/P Y L(Y ,r+ ) Y 1 r 1 The LM Curve M s /P An increase in the Real Money Demand: Financial Crisis ( L 1 >L ) LM r r r r L 1 (Y ,r+ ) r 1 r 1 LM M s /P LM 1 Asset Market Equilibrium M/P Y L (Y ,r+ ) Y The LM Curve 10/27/2010 4 Long Run General Equilibrium in the Complete IS LM Model LM = Equilibrium is asset markets trate,r FE = Equilibrium in factor markets realinteres r* General Equilibrium (Good, asset & factor markets) IS = Equilibrium in goods markets Y Full-employment output (FE line) Output, Y 10/27/2010...
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ISLMcomplete - 10/27/2010 1 The complete ISLM model Juan...

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