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CHAPTER 14

CHAPTER 14. IS-LM Frame work & Equilibrium. Chapter Outline. The IS-LM framework & equilibrium Development of the IS curve (from ch. 12 pg 140-144) Development of the LM curve (from ch. 13 pg. 177-180 Shifts in the IS curve Changes in real spending Changes in govt. spending

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CHAPTER 14

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  1. CHAPTER 14 IS-LM Frame work & Equilibrium

  2. Chapter Outline • The IS-LM framework & equilibrium • Development of the IS curve (from ch. 12 pg 140-144) • Development of the LM curve (from ch. 13 pg. 177-180 • Shifts in the IS curve • Changes in real spending • Changes in govt. spending • Changes in the taxes • Other Variables • Equilibrium in money markets

  3. Chapter Outline cont. • Shifts in the LM curve • Changes in monetary policy • Fiscal and monetary policy • Automatic stabilizers • Discretionary fiscal policy • ‘Crowding out’ effect

  4. Development of the IS curve IS curve shows alternative combinations of the real interest rate (r) and real income (Y) such that the market for goods & services is in equilibrium The IS curve is downward sloping r IS Y

  5. Deriving the IS curve • Interest-related expenditure function (IRE) • At an interest rate of r1-5%, IRE is at e1-80 mil. • When rate of interest drops to r2-4%, IRE increases to e2- 100 mil. • IRE = Interest-sensitive consumption and investment spending r A r1 B r2 IRE e1 e2 IRE

  6. Deriving…. Y • The effect of the increase in IRE resulting from a lower r can be shown as an increase in aggregate expenditures (e) • In rate of interest • In IRE (earlier graph) • In Aggregate Expenditures (shifting e1 to e2) • In income level • IS curve is shown in Panel (2) which relates real interest rate and real income combinations reflecting equilibrium points in panel (1) – A and B Y e2 B e1 e1 (1) A Y Y1 Y2 r (2) A r1 B r2 IS Y1 Y2 Y

  7. Effect of an increase in G Y e2 • If G increases • Aggregate expenditures curve shifts from e1 to e2 • Income level increases from Y1 to Y2 • Rate of interest does not change • Thus, IS curve shifts to the right (IS1 to IS2) • Interest rate remains fixed at r1 B e1 A Y Y1 Y2 r A r1 IS2 IS1 Y1 Y2

  8. Development of the LM curve • LM (Liquidity-money) curve shows alternative combinations of the interest rate and real income such that the money market is in equilibrium LM r Y o

  9. Deriving LM curve r • Money market is in equilibrium at Point A with interest rate r1 • Now suppose that income increases. This will shift the demand curve for money from D1 to D2. • D1 corresponds to income level Y1 and D2 corresponds to Y2 • Interest rate goes up to r2 • LM curve shows equilibrium points A and B in the money market RLMS LM B B r2 r2 A A D2 r1 r1 D1 Y M/P1 M/P Y1 Y2

  10. Effect of an increase in money supply RLMS1 RLMS2 • In money supply by FED • In interest rate to r2 • Income level remains constant at Y1 • LM1 curve shifts to LM2 LM1 A r1 A LM2 r1 r2 B r2 B Y MS1 MS2 M/P Y1

  11. Effect of an increase in Price level Draw Graph and Explain.

  12. Equilibrium in IS-LM framework This Equilibrium shows the level of interest rate and real income where there is simultaneous equilibrium in both money market and the market for goods and services r MS re A IS O Y Ye

  13. Effect of an increase in G • In G • Shift in IS1, curve to IS2 • New equilibrium at point B • Interest rate (r1 to r2) • Income level (Y1 to Y2) LM r B r2 C A r1 IS2 IS1 Y Y1 Y2 Y3

  14. Effect of an increase in G…. • Crowding out refers to a decrease in IRE that occurs when interest rate rises due to an increase in G • When government borrows funds to finance increase in G in the financial market, interest rate goes up due to an increase in demand. The difference between point C and B shows crowding out effect

  15. Effect of an increase in Money Supply LM1 • In money supply by Fed shift in LM curve • In interest rate • In income level LM2 A r1 B r2 IS o Y1 Y2

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