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r0Interest rateQuantity of moneyrMMs0r1Interest rateIncomerYLM0Md (Y0)ABCr1r0ABY0Y1Ms1LM1Figure 6.9 – Shifts in the LM Schedule with an Increase in theQuantity of MoneyMoney MarketThe LM SchedulesMccc02201sMccc12201
When Mdincreases for a given level of Y and r (Figure 6.10):Initial equilibrium is A in the money market corresponding to income level Y0.Money demand Md0(Y0).Equilibrium r is at r0and LM0.Assume Mdfunction shifts to Md1(Y0), an increase in Mdfor a given level of Y.At the unchanged level of income, Y0, equilibrium in the money market requires r of r1.Contd.
The new LM function, LM1 for a given level of Y0 will be above the initial LM curve.Shown by point B in panel (b):Similarly maintaining equilibrium in the money market at r0, after the shift in the Mdschedule would require a fall in the Y to a level below Y0which would shift the schedule back to original Md0(Y0).Thus the point on LM1at r0is to the left of LM0as shown by C.A shift in the Mdfunction 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.
r0Interest rateQuantity of moneyrMMs0r1Interest rateIncomerYLM0ABCr1r0Y0LM1Md1(Y0)Md0(Y0)Figure 6.10 – Shifts in the LM Schedule with a Shift in the Money Demand FunctionMoney MarketThe LM Schedule
Summary of the LM curve:LM schedule shows combinations of Yand rthat produce equilibrium in the money market.LM slopes upward.LM is relatively flat if interest elasticity of Mdis relatively high (LM relatively steep if interest elasticity of Mdis relatively low).Increase in Mswill shift LM to the right (a decrease in Mswill cause LM to shift to the left).LM will shift upward (left) with a shift in the Mdfunction 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 ScheduleThe condition for equilibrium in the product market isY = C + I + G(7)orI + 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 Iand 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.
rrYSIYI2I1I0Y2Y1Y0I2 = S2(a) Investment and Savings schedules(b) The IS ScheduleFigure 6.11: Construction of the IS Schedule ( T = G = 0)Interest RateSavings InvestmentIncome I(r)r2r1r0I1 = S1I0 = S0S(Y)Interest Rater2r1r0Y2Y1Y0CABIS
At r0, investment is I0Savings that is equal to I0is shown as S0along the savings function;This level of saving results if income is Y0;Therefore, for r0