The point of intersection E is the only point of general equilibrium for the

The point of intersection e is the only point of

• 114

This preview shows page 70 - 78 out of 114 pages.

The point of intersection ( E ) is the only point of general equilibrium for the two markets. In any case, if the money market is in equilibrium, the bond market must also be in equilibrium. Thus, the intersection (r 0 , Y 0 ) produce a simultaneous equilibrium for the money market, product market and bond market.
Diagram: IS and LM Curves Combined Y r LM r 0 Income Interest Rate IS Y 0 E The point of intersection of the IS and LM curves gives the combination of the interest rate and income (r 0 , Y 0 ) that produces equilibrium for the money and product markets.
Nature of IS-LM Equilibrium Why are other points other than E are not points of equilibrium? Consider, Points A and B , above the LM curve At points above LM, there will be excess supply of money ( XS M ). At the level of income for either A or B , interest rate is TOO HIGH for money market equilibrium. With an excess supply of money, there is a downward pressure on interest rate ( see downward directed arrow ); There is tendency to move towards the LM schedule. Consider Points C and D, below the LM schedule There will be an excess demand for money ( XD M ) and A consequent upward pressure on the interest rate ( see upward direction arrow ).
Adjustment to the Equilibrium of the IS-LM Curve Model Y r LM Income Interest Rate IS E A D C B XD O XS M XS O XD M XS M XS O XD M XD O F H
Adjustments to the Equilibrium... At such Points B and C to the right (above) of IS curve Output (i.e. aggregate supply) will exceed aggregate demand; or Analogously, S+T will exceed I+G. At the level of interest rate for B or C, the corresponding output level that will equate I+G to S+T, given by the point along the IS curve, is below the actual output level. There is an excess supply of output ( XS O ) ;and a Consequent downward pressure on output , indicated by arrows pointing left At points to the left of the IS schedule, such as A and D Actual output is below the level that will clear the product market There is excess demand for output ( XD O ) There will be an upward pressure on output, indicated by rightward directed arrows
Adjustments to the Equilibrium... Points on one schedule and not on the other are also disequilibrium points relative to one of the two markets. E.g. Point F is a point of equilibrium for the money market but a point of excess supply for the product market. Point H is a point of equilibrium for the product market but a point of excess demand for the money market. Only at Point E There is no excess demand or supply in either product or money markets. There are no pressures for the interest rate or output to change.
Algebra of the IS-LM Model Recall, a linear form of the LM equation is: M S = M d M d = c 0 + c 1 Y – c 2 r {c 1 ; c 2 > 0} M S = c 0 + c 1 Y – c 2 r Equation states that the fixed money supply ( M s ) is equal to the demand for money ( M d ) which depends positively on the level of income ( Y ) and negatively on the interest rate ( r ).