MIT14_02F09_lec11_12

# MIT14_02F09_lec11_12 - IS IS-LM Roadmap 1 MARKET I GOODS...

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IS IS LM LM IS-LM

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Roadmap 1) MARKET I : GOODS MARKET goods demand = C + I + G (+NX) = Y = goods supply (set by maximizing firms) IS curve 2) MARKET II : MONEY MARKET money demand = L d (Y, r + π e ) = M s /P = money supply (set by the Fed) LM curve IS-LM EQUILIBRIUM = EQUILIBRIUM IN BOTH MARKETS I and II IS LM EQUILIBRIUM EQUILIBRIUM IN BOTH MARKETS I and II 2
= Goods Market IS curve represents the equilibrium in the goods market: (1) Y = C + I + G + NX C + I + G + NX Y Recall the definition of private savings S (hh) = Y – T – C Recall the definition of national savings S = S (hh) + T – G Combining them (2) S = Y – C – G F (1) d (2) th d d id f th b itt From (1) and (2) the demand side of the economy can be written as: S = I + NX The IS curve is named as it is because it documents the relationship between Investment and Saving (holding NX constant). 3

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I Demand side : the IS curve C is a function of PVLR (Y, Y f , W), tax policy, expectations, etc. is a function of r, A f , K, and investment tax policy. G is a function of g overnment polic y (we will discuss this shortly) NX we will model in the last lecture of the course (for the U.S., NX is small) The IS curve relates Y to r . How do interest rates affect Y? As r falls, Investment increases (due to firm profit maximization behavior). Also Consum ption increases ( substitution effect dominates ) 4 IS curve is downward sloping in {r, Y} space .
IS Curve: Graphical Derivation S curve (Y=Y 1 ) I curve r r r* r* Y I,S Y 1 5

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IS Curve: Graphical Derivation S curve (Y=Y 1 ) I curve r r IS S curve (Y=Y 2 ) r 1 r 2 Y I,S Y 1 Y 2 An increase in current Y leads to more desired S An increase in current Y leads to more desired S, hence the equilibrium r needs to be lower! 6
IS curve r r* r* IS Y Y Suppose r is set by the Fed at the level of r* (we will explore this in depth later in the course). For a given r, we can solve for the level of output desired by the demand side of the economy. We represent the demand side of the economy represent the demand side of the economy, drawn in {r Y} space as the I drawn in {r,Y} space as the I-S curve S curve. Why IS? Because the demand side of the economy can be boiled down to I = S (when NX is zero) 7

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What shifts the IS curve What shifts the IS curve to the right? Anything that increases C, I or G (or NX when we model it): hi gher exp ected income or wealth hi gher PVLR hi g her C higher conusmer confidence higher PVLR higher C higher Tr or lower T (if the Ricardian equivalence fails) higher C higher expectations about A f higher MPK f higher MPK higher I higher I higher business confidence higher MPK f higher I lower δ or mm, or lower t K lower adjusted user cost of K higher I higher G Chang es in r WILL NOT cause IS curve to shift (causes movement along IS curve) 8
IS shift: Fall in Consumer Confidence Imagine S decreases I curve r S curve (Y=Y 1

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