Contd r Interest rate Quantity of money r M M s r 1 Interest rate Income r Y LM

# Contd r interest rate quantity of money r m m s r 1

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Contd.
r 0 Interest rate Quantity of money r M M s 0 r 1 Interest rate Income r Y LM 0 M d (Y 0 ) A B C r 1 r 0 A B Y 0 Y 1 M s 1 LM 1 Figure 6.9 – Shifts in the LM Schedule with an Increase in the Quantity of Money Money Market The LM Schedule s M c c c 0 2 2 0 1 s M c c c 1 2 2 0 1
When M d increases for a given level of Y and r (Figure 6.10): Initial equilibrium is A in the money market corresponding to income level Y 0. Money demand M d 0 (Y 0 ). Equilibrium r is at r 0 and LM 0. Assume M d function shifts to M d 1 (Y 0 ) , an increase in M d for a given level of Y. At the unchanged level of income, Y 0 , equilibrium in the money market requires r of r 1. Contd.
The new LM function, LM 1 for a given level of Y 0 will be above the initial LM curve. Shown by point B in panel (b): Similarly maintaining equilibrium in the money market at r 0 , after the shift in the M d schedule would require a fall in the Y to a level below Y 0 which would shift the schedule back to original M d 0 (Y 0 ). Thus the point on LM 1 at r 0 is to the left of LM 0 as shown by C. A shift in the M d function that increases the demand for money at a given level of both the r and Y shifts the LM schedule upward and to the left and vice versa. Contd.
r 0 Interest rate Quantity of money r M M s 0 r 1 Interest rate Income r Y LM 0 A B C r 1 r 0 Y 0 LM 1 M d 1 (Y 0 ) M d 0 (Y 0 ) Figure 6.10 – Shifts in the LM Schedule with a Shift in the Money Demand Function Money Market The LM Schedule
Summary of the LM curve: LM schedule shows combinations of Y and r that produce equilibrium in the money market. LM slopes upward. LM is relatively flat if interest elasticity of M d is relatively high (LM relatively steep if interest elasticity of M d is relatively low). Increase in M s will shift LM to the right (a decrease in M s will cause LM to shift to the left). LM will shift upward (left) with a shift in the M d function that increases the amount of money demanded at given levels of Y and r, and vice versa. Contd.
Product Market Equilibrium (IS) Construction of the IS Schedule The condition for equilibrium in the product market is Y = C + I + G (7) or I + G = S + T (8) IS schedule is constructed from equation (8). Look at a simplified case without government sector (G and T is zero) Rewrite equation (8) as: I(r) = S(Y) (9) Equation (9) indicates that I depends on r whilst S depends on Y.
We need to find a combination of r and Y that will equate I and S. Figure 6.11 shows the construction of the IS schedule. The I function is negatively sloped (panel a ): I is negatively related to r. The S function is positively sloped (panel a ): S is positively related to Y. The slope of the saving function is the marginal propensity to save (MPS). Contd.
r r Y S I Y I 2 I 1 I 0 Y 2 Y 1 Y 0 I 2 = S 2 (a) Investment and Savings schedules (b) The IS Schedule Figure 6.11: Construction of the IS Schedule ( T = G = 0) Interest Rate Savings Investment Income I(r) r 2 r 1 r 0 I 1 = S 1 I 0 = S 0 S(Y) Interest Rate r 2 r 1 r 0 Y 2 Y 1 Y 0 C A B IS
At r 0 , investment is I 0 Savings that is equal to I 0 is shown as S 0 along the savings function; This level of saving results if income is Y 0; Therefore, for r 0