GOODS AND FINANCIAL MARKETS: IS-LM MODEL SHORT RUN IN A CLOSED ECONOMIC SYSTEM

Transcription

1 GOODS ND FINNCIL MRKETS: IS-LM MODEL SHORT RUN IN CLOSED ECONOMIC SSTEM

2 THE GOOD MRKETS ND IS CURVE The Good markets assumpton: The producton s equal to the demand for goods Z; The demand s the sum of consumpton, nvestments and government spendng. Z=C(-T)+I+G; The equlbrum condton s gven by =Z such that =C(- T)+I+G.

3 INVESTMENTS Before we assumed nvestment to be constant. Investment depends on two factors: Producton: here we assume that the producton to be equal to the level of sales. n ncrease n the level of sales needs to ncrease the frm s producton. To do so, t need to mprove ts endowment buyng,.e., addtonal machnes. The frm need to nvest. The nterest rate: to buy new machnes the frm should borrow. If the hgher the nterest rate, the less attractve t s to borrow and buy other machneres. In fact the return of payments won t cover the nterest payments and so the nvestment won t be worth. I = I(. )

4 NEW OUTPUT FORMUL IS: = C T + I, + G

5 DERIVING THE IS CURVE ; Z Z > ZZ For > c 1 ZZ Z < c 0 + I+G c 1 T 45

6 DERIVING GRPH OF IS CURVE Z Z > Z Z Z <

7 DERIVING THE IS CURVE 2 S S 45 I IS I

8 SHIFTS OF THE IS CURVE IS (for a gven T) Government nterventon on Taxaton and Government spendng shfts the IS curve for each nterest rate and output. level IS (for T > T)

9 FINNCIL MRKETS EQUILIBRIUM ND LM CURVE Before startng to analyze the fnancal market equlbrum, t s mportant to recall n mnd the man assumpton of the short run. 1 st fxed prce level; 2 nd fxed wage M P = L()

10 DERIVING THE LM CURVE M s M d M d n ncrease n output level leads an ncrease n the demand for transacton money, t mples a shft of the lqudty demand on the rght hand sde. So people want to hold money and the ncrease of the nterest rate that leads to want to hold less money. M M

11 DERIVING LM CURVE 1 M s M d M d M M

12 L T L T L S LM L S

13 IS-LM EQUILIBRIUM IS equlbrum: the supply of goods s equal to the demand for goods. LM equlbrum: the supply of real money s equal to the demand for money IS: = C T + I, + G LM: M P = L()

14 IS-LM MODEL IS LM IS curve: any pont on the downward-slopng curve corresponds to equlbrum n goods markets; LM curve: any pont on the upward-slopng curve corresponds to equlbrum n fnancal markets: Pont.: ths pont corresponds to equlbrum condtons satsfed

15 FISCL POLIC ND INTEREST RTE Consder the Publc Savng: G-T ths s the budget equlbrum : If (G-T) decreases: fscal contracton or consoldaton; If (G-T) ncreases: fscal expanson. Suppose the Government wants to ncrease the budget defct: t reduces the taxes. What happens to the IS-LM equlbrum? How does the fscal expanson affect the fnancal equlbrum? Descrbe the effects.

16 THE FISCL EXPNSION IS IS LM 1 the taxes 'reducton leads an ncrease n dsposable ncome and, as consequence, an ncrease n consumpton; 2 we assst to an ncrease both the aggregate demand and, for the IS assumpton, general output. 3 Consequently the IS curve shfts to the rght, from IS to IS. 4 the fscal expanson doesn t affect the LM equlbrum so the curve doesn t shft. 5 the economy moves along the LM curve, n fact the nterest rates runs up to mantan the same level of the real supply of money Crowdng out of nvestments

17 EXPNSIONR MONETR POLIC IS LM LM 1 st CB decdes to mplement the supply of money n the economy. What happens? (remnd to expansonary open markets operatons). Why do the nterest rate decrease? 2 nd The nterest rate s decrease leads to an ncrease of the demand for transactons, an ncrease n nvestments and, n turn, o n demand and output. 3 rd the economy moves along the IS curve;

18 THE FISCL POLIC MULTIPLIER Before dervng the fscal polcy multpler, focus our attenton on the IS equaton = C(-T)+I(,)+G The lnear consumpton equaton s equal to : C = c 0 + c 1 T c 0 > 0 and < c 1 < 1; The lnear nvestment demand s : I = I + d 1 d 2 d 1, d 2 > 0 The IS lnear equaton s = c 0 + c 1 T + I + d 1 d 2 + G; solvng the equaton by = 1 d 2 1 c 1 d 1 1 c 1 d 1 = 1 d 2 1 c 1 d 1 d 2

19 THE MONETR POLIC MULTIPLIER Consdere the LM curve equaton: M P = L(); The lnear equaton s : M P = f 1 f 2 f 1, f 2 > 0 The LM equlbrum equaton = 1 f 1 M P + f 2 f 1

20 THE IS-LM EQUILIBRIUM IN FORMUL IS: = 1 1 c 1 d 1 d 2 1 c 1 d 1 LM: = 1 f 1 M P + f 2 f 1 = = 1 1 c 1 d 1 f 2 d 2 + f 1 f d 2 f 1 1 c 1 d 1 M P c 1 d 1 + f 1 f2 d 2 M P c 1 d 1 f 2 f1 + d 2 The Monetary Polcy Multpler The equatons show us that both varables and are n functon of exogenous varables: the money supply and the utonomous spendng. n ncrease of leads an ncrease n Output and n nterest rate. n ncrease of M/P leads an ncrease n but a decrease of nterest rate The Fscal Polcy Multpler

21 HOW DOES THE IS-LM MODEL FIT THE FCTS? Introducng dynamcs formally would be dffcult, but we can descrbe the basc mechansms n words. Consumers are lkely to take some tme to adjust ther consumpton followng a change n dsposable ncome. Frms are lkely to take some tme to adjust nvestment spendng followng a change n ther sales. Frms are lkely to take some tme to adjust nvestment spendng followng a change n the nterest rate. Frms are lkely to take some tme to adjust producton followng a change n ther sales. 21 of 33

22 HOW DOES THE IS-LM MODEL FIT THE FCTS? The Emprcal Effects of an Increase n the Federal Funds Rate In the short run, an ncrease n the federal funds rate leads to a decrease n output and to an ncrease n unemployment, but t has lttle effect on the prce level. 22 of 33