Macroeconomics

Sheet 2
Outline

Short run economics

Market for goods
• - Equilibrium in goods market and capital market
• - Aggregate output Equation
• - Breaking down the equation
• - Consumption

IS/ LM model
- IS (goods market equilibrium)
-LM (financial market equilibrium)
 Short run economics
Market for goods
• Prices are fixed in the short run. While supply is totally elastic.
• Demand derives economic activities.

• Equilibrium in goods market

 Market for goods

• When we substitute the components of Y into our equation, we get this:

 Market for goods

• Breaking down the components  Ca is autonomous consumption

• Consumption
 c is the propensity to consume

 Y a is the available income

 Market for goods

• Equilibrium
• 1st: Consumption graph
 Market for goods

• Equilibrium
• 2nd: when Y = Y (when
ad the
demanded amount matches the
supplied output, we have 45
degree line which represents all
the potential points for
equilibrium.
 Market for goods

• Equilibrium
• 3rd: putting 2 graphs together
• 4th: moving from the initial
equilibrium
• What if c changes?
• What if Ca changes?
Sheet 2
Task 1

What do we mean when we refer to the “short-run.”

The short-run is the time when prices are fixed.

Task 2

What do we mean when we speak about the equilibrium in

the goods market?

Supply meets demand

All who are willing to pay the equilibrium price are
getting what they demand
All producers are at a marginal cost that equal or
below the market price
Task 3

Prepare a graph that shows all potential equilibria in the goods

market.
Task 4

Write down the formula for the demand Y d for the short-run.

The formula for the short-run demand is

Task 5

How is consumption C defined?

 Consumption C consists of
 autonomous consumption Ca that is independent of
available income and the consumption that depends on
the available income c · Y a.

 c is the marginal propensity to consume. c is between 0

and 1

 For example, c = 0.5 indicates that 50% of available

income is used for consumption.
Task 6

Graph the consumption function.

Task 7

Define available income.

Available income is the difference between income Y and taxes T.

Task 8

Substitute the formula for consumption into the formula for short run
demand.
Task 9

Prepare a graph that shows all potential equilibria for the goods
market and add the short-run demand function.
Task 10

What does the intersection of the functions in the graph from Task 9 tell you?

 The intersection indicates the short-run equilibrium on the goods

market: Y = Y . The superscripts indicate supply s and demand d.
d s
Task 11

Show formally and graphically what happens to the equilibrium on the goods
market when Ca increases.

 When Ca increases by 1 unit,

the equilibrium on the goods
market increases by 1 unit.
Task 12

Show graphically what happens to the equilibrium on the goods

market when c increases.

 When c increases, the slope of

the demand function increases.
 Short run economies
IS/LM model

• Explains how monetary policy (change in quantity of money and

interest) affects the output

• 1st step: we need to figure out the relationship between interest

and investment from the market for goods and then reflect on the
aggregate output to determine the IS curve

• 2nd step: we need to figure out the relationship between the

quantity of money and interest rate from the liquidity preference
model and then reflect on the aggregate output.
 1st step: IS curve • Net exports also relates to the interest rates
• the higher the domestic interest rates, the
• Investment depends on interest
more desirability the investments in assets
rates
such as bonds for the foreigners which affects
• the lower the cost of borrowing,
the money demand.
the higher the level of investment
• Hence the prices of the domestic products will
(-ve relation)
increase which decreases the net exports. (-ve
relation)
 1st step: IS curve

• Investment & Net exports are

components of the aggregate output.

• Which means if they have negative

relationship with the interest rate, it is
reflected on the output.

• So, the higher the interest rate, the lower

the investment and the net exports.

• Hence, the higher the interest rate, the

lower the aggregate output (-ve relation)
 2nd step: LM curve
• It is derived from the liquidity
preference model in which people
either hold cash or bonds.

• Cash has no interest rate but it has

a forgone opportunity cost which
is the bond interest rate.

• Money supply is determined by

the central bank only so it is fixed.

• Money demand depends on how

much people are willing to hold
cash instead of bonds which highly
related to income and price levels
(inflation)
 2nd step: LM curve
• So, from the liquidity preference model.

• If income increases, people demand more

money to spend more on goods and
services which means that the demand for
money increases (money demand shifts to
the right and the interest rate increases)

• Also the demand for goods increases and

hence the aggregate output increases
• In the short run, supply of goods is
totally elastic and is derived by the
change in demand.

• So, the higher the interest rate, the higher

the aggregate output (+ve relation)
Task 13

Prepare a graph that shows the relationship between the interest

rate i and investment I.

 The higher the interest rate i, the

higher the cost of borrowing
money.
 This drives investment I down
Task 14

What happens to the equilibrium on the goods market when the

interest rate i increases? Prepare a graph.

 The higher the interest rate i, the

higher the cost of borrowing
money.

 This drives investment I down

 Hence, the aggregate output

decreases
Task 15

Scrutinize the graph you prepared in Task 14. What do you learn
about the relationship between the interest rate and output Y ? Prepare a graph.
 The higher the interest rate i, the higher
the cost of borrowing money.

 This drives investment I down

 So the higher the interest rate, the lower

the output
THANKS

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