ECON 202-lecture-29.03.2011 - ECON 202 MACROECONOMIC THEORY...

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C O U R S E L E C T U R E ; M A R C H 2 8 - 2 9 - 3 1 , 2 0 1 1C H A P T E R 5 - G O O D S A N D F I N A N C I A L M A R K E T S : T H E I S - L M M O D E LECON 202 MACROECONOMIC THEORY
What this chapter is aboutWe introduce the interaction between the goods and the money markets in an economyBasically, we study how interest rates and output&income are determined in the goods and money markets simultaneouslyA short run analysisWhat is meant by the “short run”?Short run is the time frame during which demand side policies (i.e. monetary and fiscal policies) could have an effect on output and income29.03.20112
OUTLINEThe Goods Market and The IS-RelationDetermining outputDeriving the IS curveShifts in the IS curveThe Money Market and the LM curveThe Demand for MoneyThe Money Supply and the Money Market EquilibriumShifts in the LM curveSimultaneous Equilibria in the Money and Goods MarketsMonetary Policy EffectsFiscal Policy EffectsSpecial Cases: Liquidity trap, and the Classical casePolicy Mixes29.03.20113
The Goods Market and The IS RelationIS-curve: a relationship which shows combinations of output and interest rate which are alternative equilibria in the goods marketAt every point on the IS curve, desired expenditures equal income, or the goods market is in equilibriumWe derive the IS curve in two steps:1.Derive the investment relation (or, the investment demand schedule)2.Replace the investment relation in the aggregate demand identity, ZC+I+G; and determine the combinations of income and interest rate that clear the goods market.29.03.20114
Investment DemandSo far in our analysis, we considered I to be a constant value;However, this is not entirely realistic;Investment demand is affected byInterest rate (the rate of borrowing)The volume of sales (income level is a proxy for the volume of sales)Investment demand function:For the time being, assume that I is affected only by changes in the interest rate.),(iYII29.03.20115
Investment DemandAssume a linear investment demand function:The constant parameter b measures the sensitivity of investment to changes in interest rateIt is the slope of the investment demand fucntionIIbibbiII10,29.03.20116
Investment DemandĪ/bĪiIibIbIiIIbi11iIFlat I-functionSteep I-functionFlat I-function: b is large; I is highly sensitive to changes in i;Steep I-function: b is small; I is not verysensitive to changes in i.29.03.20117Δi(slope)
Deriving the IS-curve29.03.20118Aggregate Demand:Consumption function:GbiITYCGICADZ)(TRtYTYtccTRcTRtYYccTYcccYcCD)1()()(0000
Deriving the IS-curve29.03.20119Aggregate Demand function becomes:

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