Macroeconomics 2 Page 23
The IS-LM model establishes simultaneous equilibrium in the goods and money market. Product market: Real GDP/income/economic activity depends on the level of autonomous planned spending. RGDP = Y = AE = C+I+G+NX. Autonomous planned spending (Ca and Ip) is affected by (“depends on”) interest rates. Ap(Y As r ↑, the cost of borrowing rises and interest - sensitive consumption and investment ↓. Positively related to income but negatively related to interest rate. IS curve: is the schedule that identifies the combinations of income and interest rate at which the product/commodity market is in equilibrium. At any point off the IS curve, the economy is out of the equation in the product. If economic activity was Y0 any position lower than point A would have a lower interest rate, resulting in an increase in autonomous planned expenditure above the income level, a negative in unplanned investment, and excess demand for goods and services. The IS curve shifts by the change in Ap times the multiplier • Shifts: any increase in planned autonomous spending shifts the IS curve to the right (and vice versa) The more responsive Ap is to interest rates, the flatter the IS curve. • The higher the multiplier, the flatter the IS curve. • Slope: the slope of the IS curve reflects the responsiveness of Ap to interest rates. Extended IS: Y=k(Ap – br), where b is interest responsiveness The supply of money (Ms) is controlled by the Central Bank. • The real quantity of money demanded (M/P)d depends on both income (Y) and interest rates (r). • At the original interest rate the increase in Y would result in an increase in Md, resulting in excess demand for money. • Money market: Week 8 Lecture Notes Tuesday, 24 September 2019 1:59 PM Macroeconomics 2 Page 24
excess demand for money. The LM Curve shows all the possible combinations of Y and r such that the money market is in equilibrium. If MS increases, LM shifts → right If P increases, LM shifts → left LM curve: is the schedule that identifies the combinations of income and interest rate at which the money market is in equilibrium- where the demand for real money balances is equal to the supply. At equilibrium, real MS equals real Md: Equilibrium interest rates Save= buying bonds and other financial assets, this would cause prices to increase on bonds but a decrease in the yield of bongs. 1. Spend= buying goods and services which would stimulate the market. 2. If money demand becomes more responsive to income the LM curve becomes steeper. 3. If money demand becomes more responsive to interest rates Md becomes flatter the LM becomes flatter. 4. Macroeconomics 2 Page 25
If the goods market is out of equilibrium , involuntary inventory decumulation or accumulation occurs, firms respond by increasing or decreasing production, Y moves to equilibrium • If the money market is out of equilibrium, pressure on interest rates will bring back monetary equilibrium • An expansionary monetary policy is one that has the effect of lowering interest rates and raising GDP •
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