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Macroeconomic equilibrium in the real and in the monetary sector: The IS-LM model

Macroeconomic equilibrium in the real and in the monetary sector: The IS-LM model. Frederick University 2014. Macroeconomic equilibrium in the money market. LM – curve of the equilibrium on the money sector On each point of the curve MS = MD. MD 1. MD 2. MS. LM. i. i 2. i.

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Macroeconomic equilibrium in the real and in the monetary sector: The IS-LM model

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  1. Macroeconomic equilibrium in the real and in the monetary sector:The IS-LM model Frederick University 2014

  2. Macroeconomic equilibrium in the money market LM – curve of the equilibrium on the money sector On each point of the curve MS = MD MD1 MD2 MS LM i i2 i i1 i1 Y1 Y M/P Y2 Income rises and MD increases The equilibrium interest rate increases

  3. Analysing the LM curve The slope of the curve depends on the EMD as regard Y i The slope of the LM curve depends on The elasticity of MD as regard income and on The elasticity of MD as regard interest rate LM If the Ey is high and the Eiis low, the curve is steep y

  4. Analysing the LM curve All the points on LM present an equilibrium on the money market (MS = MD) and show what should the interest rate (i) be at the given level of income (Y), so that MS = MD A’ i If the economy is in point A, the i is too low for the given y. At this low interest rate the public will want to hold more liquidity. MD > MS. Therefore, they will start selling their bonds in order to get more liquidity. The supply of bonds will increase and the interest rate will rise. A LM i1 Y y1

  5. Factors, determining LM LM1 • MS i MS1 MS2 i LM2 A1 i1 i1 MD i2 i2 A2 M/P Y Y MS increase and the equilibrium interest rate falls. At the same level of income, MS = MD at a lower interest rate. LM shifts to the right

  6. Factors, determining LM LM2 LM1 • MD i MS MD2 i A2 i2 i1 i1 A1 i2 MD1 M/P Y Y MD increase and the equilibrium interest rate rises. At the same level of income, MS = MD at a higher interest rate. LM shifts leftwards

  7. Macroeconomic equilibrium in the real sector • Investment demand depends on the interest rate • Savings depend on income • Therefore, there is not a single variable to clear the capital market • The equilibrium in the capital market depends on both income (Y) and interest rate (i)

  8. Macroeconomic equilibrium in the real sector AE2 E2 the interest rate falls And investment spending increases AE1 AE IS – curve of equilibrium in the real sector Supply of loanable funds = Demand for loanable funds АЕ = Yon each point E1 Y Y2 Y1 Slope – depends on the elasticity of investment demand as regards the interest rate i IS i1 i2 Y Y1 Y2

  9. Analysing the IS curve The slope of the IS curve depends on the elasticity of Investment demand as regard interest rate i IS If the Eiis low, the curve is steep All the points on IS present an equilibrium on the real sector (AE = Y) and show what should be the income (Y) be at every level of interest rate (i), so that AE = Y A A’ Y If the economy is in point A, the Yis too low for the given i. At this low interest rate businesses will want to invest more. AE > Y. Inventories will fall and firms will increase orders to suppliers. Income will start rising until AE = Y at point A’

  10. Factors, determining IS: Injections and Leakages AE2 AE1 IS – curve of equilibrium in the real sector АЕ = Yon each point AE Government spending rises at the same level of interest rate and Y increases Y Y2 Y1 Point A shifts to the right to point A’, where will be the new equilibrium at i1 The IS curve shifts rightwards i IS A A’ i1 The increase in injections and the decrease in leakages shift the IS curve to the right. The decrease in injections and the increase in leakages shift the IS curve to the left i2 Y Y1 Y2

  11. Equilibrium in the real sector and in the financial sector Increase in exports ISshows what should the income be at everylevel of i. With the increase in exports, Y rises and ISshifts rightwards. This destroys the equilibrium in the monetary sector. LM shows what should the interest rate be at every level of Y. At the higher income level Y2i1 is lower than the equilibrium i. The public starts selling bonds, because they prefer more liquidity.MD rises. PVofbonds falls. PV = FV/f(i). The interest rate rises. IS1 i IS2 LM Е2 Е1 i1 Y2 Y In the real sectorinvestment falls, Y decreases and savingsfall too. The new equilibrium is achieved at point Е2 Y1

  12. Equilibrium in the real sector and in the financial sector MSincreases i LMshows what the interest rate should be at every level of income. The increase in MSreduces the i atthe same income levelY1. IS E1 At a lower interest rate, however, I increase and AE > Y. Inventories fall, Y rises, and S increase, as well. Е2 At the same time MD increases and the interest rate rises. LM1 LM2 The new equilibrium is set at Е2 Y1 Y

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