Goods Market Equilibrium

IS Curve
Goods

market equilibrium is derived using IS curve

The

IS curve (schedule) shows combinations of interest rates and levels of output such that planned spending equals income

Investment
Some

facts:

Investment is the principal link between the present and future Between money market and goods market Volatility in investment is considered responsible for fluctuations in GDP Investment spending is affected by interest rate (monetary policy) and tax policies (fiscal policy)

Investment
Investment

is the flow of spending that adds to the physical stock of capital is the stock, the given Rupee value of all the buildings, machines and inventories at a point of time

Capital

Determinants of Investment
Marginal

the increase in output produced by using 1 more unit of capital in the production The renter (user) cost of capital is the cost of using 1 more unit of capital in production (rate of interest, i) Real cost of borrowing is expected rate of interest

product (efficiency) of capital (mec) is

minus expected inflation rate Cost also includes depreciation

Thus,

rc = r + d = i-n^ + d

Determinants of Investment ..
Diminishing

as capital is increased Firms desire to add capital until the marginal return to the last unit added drops to the rental cost of capital (desired capital stock) That is, for firms to undertake investment, mec rc The general relationship among the desired capital stock, K*, the rc and the level of output is given by
K* = g(rc, Y)

mec means marginal product drops

Determinants of Investment ..
Expected

output Y Taxes and rental cost of capital

Corporate tax Investment Allowances
Thus,

both fiscal and monetary policy affect the desired capital stock Stock market and capital stock (q Theory)
Tobins q = Market value / Replacement cost Gain = q-1

Investment measured
Kt

= Kt-1 + (K*- Kt-1) is the fraction of gap So I = Kt - Kt-1

Investment and Interest rate

So far, investment spending (I) was treated as entirely an exogenous variable But some component of I also depends upon interest rate Using these ideas, investment function for our AD framework can be defined as

I I bi; b 0

Where i is the interest rate and coefficient b measures responsiveness of I to the interest rate

Interest rate and AD: IS curve

AD C I G NX AD C cTR c(1 t )Y ) ( I bi) G NX AD A c(1 t )Y bi where A C cTR I G NX Inequilibrium Y AD A c(1 t )Y bi Simplifing Y G ( A bi)

IS Curve
Goods

market equilibrium is derived using IS curve

The

IS curve (schedule) shows combinations of interest rates and levels of output such that planned spending equals income

More on IS curve
Slope Shift

depends upon b and multiplier

is caused by increase in the level of autonomous spending

Money Market Equilibrium

Money Market Equilibrium

LM

curve is the money market equilibrium schedule It shows combinations of interest rates and levels of output such that money demand equals money supply First, money demand is set L = f(Y,r) Second, we equate money demand with money supply Then, LM curve can be derived

What is Money?
Money

is the means of payment or medium of payment is whatever is generally accepted in Exchange

Money

What Constitutes Money?

From

barter system to ATM

There is no unique set of assets that will always constitute money

Over the course of time, the particular assets that serve as a medium of exchange, or means of payment, will change further

Characteristics of Money
Medium

of exchange:

Money is anything that people will accept in exchange for goods and services in the belief that thy may, in turn, exchange it now or later, for other goods and services

Characteristics of Money
Store

of value:

An object used as money must retain its value because the object is used in separate exchanges over time

Unit of account:
Standards that is sued to measure value. Unit in which prices are quoted and books are kept

Demand for money

Demand

for money is a demand for real balances M/P

People hold money for its purchasing power, for the amount of goods they can buy with it Therefore real money demand is unchanged when price level increases; or nominal money demand increases in proportion to the increase in the price level

Factors influencing demand for money?

Transactions motive for making regular payment Precautionary motive to meet unforeseen
contingencies

Speculative motive uncertainties about the money

value of other assets
There is a trade off between the benefits of holding more

money verses the interest costs of doing so

Interest rate on money is referred to as the own rate of

interest and the opportunity cost of holding money is equal to the difference between the yield on other assets and the own rate

More on Demand for Money

Demand for real money balances responds negatively to the rate of interest for money increases with the level of real

Demand

income

Short-run

responsiveness of money demand to changes in interest rates and income is considerably less than long run responses

Demand for money

That is,

L = f (Y,r) L is positively related to Y, negatively related to r That is, L can be expressed as L = kY hi ; k,h > 0 parameters k and h reflect sensitivity of demand for money to the level of income and interest rate

More on LM curve
Slope Shift

depends upon h and k

is caused by change in supply curve

Question
Consider the following economy: C = 400 + .75(Y-T) I = 400 2i G = 300 T = 400 Ms = 400 Md/P = .25Y-10i P= 2

a. b.

Calculate the equilibrium levels of output and interest rates Suppose the government decides to eliminate a budget surplus by either a tax cut of 100 or an increase in government spending of 100. What happens to output in each case?

 Answers:

i = 50 Y = 2800 When G increases, i becomes 58.3; Y = 3132 When TA decreases, i becomes 56.25

Question
Suppose

economy C= 100 + 0.8Yd M/P = Rs. 500 I = 900 50 i where i is the interest rate G = Rs. 200; TR = Rs. 62.5 Tax rate = 25 % Demand for real balances L = 0.25Y-62.5i

the following equation describe the

Question

Calculate
a. What is the equilibrium level of income and the budget surplus/deficit? b. If the government desires to maintain the balanced budget, what will be the tax rate? c. What will be the money supply required to maintain the interest rate achieved before the balance budget?

Answer
A.

Y = 2750; I = 3

Budget surplus = Rs. 425

B. t = 7.29% C. M/P = Rs. 712.5