LECTURE 8 – THE INTEREST RATE AND PRODUCTION IN THE SHORT RUN (What causes short-run

8fluctuations in productions and employment?)

Long-run

 Wages and prices are flexible

 Recall
 Production is determined by supply factors
 The real interest rate r=i-π is the rate which equates supply and demand  the natural rate of
interest
 Money supply (monetary policy) does not affect real variables
 When inflation increases, the nominal interest rate is also increased  real interest rate is
unaffected

 Real money supply is unaffected if both M and P change: M/P=

Short-run

 Prices and wages take time to adjust sometimes – sticky

 Production & employment determined by aggregate demand and may deviate from equilibrium (natral)
levels

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 Monetary policy can affect real variables in the short run
 CB controls the nominal interest rate
 Expected real interest rate may differ from natural rate
 The IS-LM model
 Shows how the nominal interest and production (income) are determined with a given price level
 Interaction between the markets for goods and services and money
 The IS equation above
 LM curve (money market equilibrium): M/P=V/V(i)
 Analyse the short-run effects of several different shocks
 What is the effect of an increase in the interest rate?
 Substitute for r=i-pie and take pi as given. Then increase the interest rate
 Higher interest reduces C and I + multiplier effect
 We can derive the IS curve graphically from the “Keynesian cross”

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