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Chapter 11 Notes – Money, interest, and income.

IS-LM model helps lead to an understanding of the determination of interest rates and of
their role in the business cycle. It also allows you to see how monetary policy affects
output. The bank of Canada controls output by controlling the supply of money. This is a
short run model.

IS Curve

The IS curve (good market equilibrium curve) shows the combinations of the interest rate
and income for which the good markets is in equilibrium.

I = I – bi

b measures the responsiveness of investment spending to interest rate. If investment


spending is highly responsive to interest rate, a small decline in rates will lead to a large
increase in investment spending, but if investment spending is not very responsive then
the investment curve will be much steeper.

Think of the loanable funds market as just another market, only instead of quantity of
good consumed on your x-axis, you've got quantity of money loaned/saved. When you
think of the price of loans, it's the interest rate that you have to pay on your loan, so
interest rate goes on the y-axis.

The investment demand curve is downward sloping because a company is only going to
invest in a project (take out a loan) if it thinks it's going to get a certain rate of profit on
the project (let's say 5%). If a project will pay 10% return and the interest rate is 3%, the
company will invest because it will make 10-3=7% profit. Projects vary, though, in their
return. When the interest rate is low (say 0%), a company will invest in every project
with 5% return and above. If the interest rate increases by 1%, the company will only
invest in projects with 6% return or above, etc. It should be pretty easy to see now that
the quantity of investment will decrease as the interest rate increases.

The curve is sloped because a higher level of interest rate reduces investment spending,
thereby reducing aggregate demand and thus the equilibrium level of income. The
steepness of the curvedepends on how sensititve investment spending is to changes in the
interest rate and also depends on the multiplier in the equation.

A given change in the interest rate produces a large change in aggregate demand. If a
given change in the interest rate produces a large change in income, the IS curve is very
flat.

Role of the multiplier

The multiplier is larger on steeper aggregate demand curves. The smaller the sensitivity
of investment spending to the interest rate and the smaller the multiplier, the steeper the
IS curve.

An increase in the tax rate reduces the multiplier so the higher the tax rate, the steeper the
IS curve.

Summary of IS curve

• The IS curve is the schedule of combinations of the interest rate and level of
income such that the goods market is in equilibrium.
• The IS curve is negativiely sloped because an increase in interest rate reduces
planned investement spending and therefore reduces aggregrate demand, thus
reducing the equilibrium level of income.
• The smaller the multiplier and the less sensitive investement spending is to
changes in the interest rate, the steeper the IS curve.
• The IS curve is shifted by changes in autonomous spending. An increase in
autonomous spending, including an increase in government purchases, shifts the
IS curve out to the right.

The money market and the LM curve


The LM curve(Money market equilibrium curve) shows combinations of interest rates
and levels of output such that money demand equals money supply. Its created in two
steps.
1. We explain why money demand depends on interest rates and income
(emphasizing that because people care about purchasing power of money, the
demand for money is a theory of real rather than nominal demand).
2. We equate money demand with money supply(Set by central bank), and find
the combinations of income and interest rates that keep the money market in
equilibrium.

Demand for Money

The demand for money is a demand for real balances because people hold money for
what it will buy. If inflation doubles then people will hold on to double the amount of
money