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**Financial Markets Together:
**

The IS-LM Model

**The Goods Market
**

and the IS Relation

• Equilibrium in the goods market

exists when production, Y, is equal

to the demand for goods, Z.

• In the simple model (in chapter 3),

the interest rate did not affect the

demand for goods. The equilibrium

condition was given by:

Y C (Y T ) I G

Sales (Y). we no longer assume I (investment) is constant • We capture the effects of two factors affecting investment: – The level of sales/income (+) – The interest rate (-) I I (Y .i) .Investment. and the Interest Rate (i) • Now.

i) G .The Determination of Output • Taking into account the investment relation above. the equilibrium condition in the goods market becomes: Y C (Y T ) I (Y .

. Equilibrium requires that the demand for goods be equal to output.The Determination of Output Equilibrium in the Goods Market The demand for goods is an increasing function of output.

.Deriving the IS Curve The Effects of an Increase in the Interest Rate on Output An increase in the interest rate decreases the demand for goods at any level of output.

. .The IS Curve Shifts of the IS Curve An increase in taxes..

Financial Markets and the LM Relation • The interest rate is determined by the equality of the supply of and the demand for M money: $ Y L (i) M = nominal money stock $YL(i) = demand for money $Y = nominal income i = nominal interest rate .

Dividing both sides by P (the price level) gives us the equation above. which depends on real M interest rate. the real money supply is equal to the real money demand. and the P Y L (i) Recall: before. i: income. and the Interest Rate • The LM relation: In equilibrium. . Y. Real Income. we had the same equation but in nominal instead of real terms (nominal income and nominal money supply).Real Money.

Deriving the LM Curve The Effects of an Increase in Income on the Interest Rate .

.. .Shifts of the LM Curve Shifts of the LM Curve An increase in money.

Equilibrium in financial markets (LM). When the IS curve intersects the LM curve. both goods and financial markets are in equilibrium. IS r e la tio n : Y C (Y T ) I (Y .i ) G L M r e la tio n : M Y L (i) P .The IS and the LM Relations Together The IS-LM Model Equilibrium in the goods market (IS).

Fiscal Policy. the Interest Rate and the IS Curve • Fiscal contraction: a fiscal policy that reduces the budget deficit. – Increasing G or decreasing T • Taxes (T) and government expenditures (G) affect the IS curve. . – Reducing G or increasing T • Fiscal expansion: increasing the budget deficit. not the LM curve.

the Interest Rate and the IS Curve The Effects of an Increase in Taxes .Fiscal Policy.

• Monetary policy affects only the LM curve. . the Interest Rate.Monetary Policy. not the IS curve. and the LM Curve • Monetary contraction (tightening) refers to a decrease in the money supply. • An increase in the money supply is called monetary expansion.

Monetary Policy. and the LM Curve The Effects of a Monetary Expansion . the Interest Rate.

Using a Policy Mix The Effects of Fiscal and Monetary Policy. Shift of IS Shift of LM Movement of Output Movement in Interest Rate Increase in taxes left none down down Decrease in taxes right none up up Increase in spending right none up up Decrease in spending left none down down Increase in money none down up down Decrease in money none up down up .

• If government spending increases. crowding out is 5000 – 4500 = 500 . Is there crowding out if government spending increases 1500? How much? • IS0 ------> Y = 4250 – 125i LM -----> Y = 2000 + 250i IS1 ------> Y = 5750 – 125i • Initial equilibrium IS0 = LM at Y = 3500 and r 0 = 6%.Crowding Out • Given Md = 0.25 + 62. • If interest rate is unchanged (6%).5i. IS -----> Y = 4250 – 125i and LM -------> Y = 2000 + 250i. then after government spending increases: Y = 5750 – 125r = 5750 – 125(6) = 5000 So. then IS1 = LM at Y = 4500 and r1 = 10%.

.

r IS1 LM0 IS0 10 6 E’ E 3500 Y E” 4500 5000 .

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