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Goods and Financial Markets 1 : IS-LM

Goods and Financial Markets 1 : IS-LM. Goal: link the goods and the financial markets into a more general model that will determine the equilibrium Y and the equilibrium i in the economy in the short run (with fixed prices)

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Goods and Financial Markets 1 : IS-LM

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  1. Goods and Financial Markets1: IS-LM • Goal: link the goods and the financial markets into a more general model that will determine the equilibrium Y and the equilibrium i in the economy in the short run (with fixed prices) • The goods market will be represented by the IS curve (standing for investment-savings) • The financial markets (money market) will be represented by the LM curve (liquidity-money) 1. The Hicks-Hansen model based on Keynes’ General Theory

  2. The goods market - IS curve • Equilibrium condition Y = Z  C + I + G • Investment will provide the link to the financial markets • Determinants of investment: • If sales increase, producers might want to increase their productive capacity Y • If the rate of interest rate i increases, producers find that borrowing to add new capital becomes more expensive

  3. Equilibrium in the goods market becomes: Y = C(Y-T)+I(Y,i) + G • Basically • When i I and Ye • When i I and Ye • The ZZ curve shifts as the interest rate changes and a multiplier effect takes place • If MPI is the marginal propensity to invest out of new income, assume that MPC + MPI < 1 • The slope of the ZZ curve is MPC + MPI and the interest rate is included in the intercept

  4. Construction of the IS curve Y=Z ZZ(i) Z When the interest rate increases, I (Y, i) drops and the ZZ curve shifts down. The economy contracts from Ye to Y’e. E and E’ correspond to 2 combinations of i and Y, such that the good market is in equilibrium. ZZ’(i’) i Y Y’e Ye i E’ i’ E i IS Y Y’e Ye

  5. The IS curve • Y = C(Y-T)+I(Y, i) + G • Definition: All the combinations of i and Y such that the goods market is in equilibrium i.e. the above equation is satisfied • Shift of the IS: A change in any of the exogenous variables in the equation will cause IS to shift. • Shift variables: • c0 and I0 (confidence variables) • T and G (policy - fiscal - variables)

  6. Expansionary fiscal policy: increase in G Y=Z ZZ’(G+∆G) Z ZZ (G) When G increases, ZZ shifts up and IS shifts to the right. An increase in T would has the opposite effect as it is contractionary. ∆G Y Ye Y’e i E’ E i IS’ IS Y Ye Y’e

  7. Shifts of IS i G T c0 I0 G T c0 I0 IS Y

  8. The financial markets - LM curve • Equilibrium condition1: supply of money = demand for money Ms = PYL(i) or Ms/P = YL(i) (Ms/P is the real money supply) • It is clear that both LM and IS are relations between i and Y 1. The bonds market is automatically in equilibrium when the money market is in equilibrium

  9. Construction of the LM curve Ms i i LM E’ i1 i0 M’d(Y1>Y0) E Md(Y0) M/P Y0 Y1 Y

  10. The LM curve • Ms = PYL(i) • Definition: All the combinations of i and Y such that the financial markets (bonds and money) are in equilibrium • Shift of the LM curve: a change in the money supply or a change in price or an exogenous shift in the money demand • An increase in the money supply ( or a decrease in price) is expansionary • A change in the velocity of money

  11. Expansionary monetary policy: an increase in Ms Ms M’s i LM i LM’ A i0 i1 A’ Md(Y0) M/P Y0 Y1 Y

  12. Shifts of LM Contractionary i LM Ms P V Ms P V Expansionary Y

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