Professional Documents
Culture Documents
90
10
0
45
10 90 Y (= output, GDP)
Cont. …
PE is the amount that the households, firms & the
gov’t would like to spend on goods & services.
For a closed economy (NX = 0), PE is the sum of
consumption(C) planned investment (I) & gov’t
purchases (G). Then:
PE = C + I + G.
To this equation, we add the following:
The consumption function: C = C(Y − T);
1
dY dG dT [dCa cdG dI dG ]
1 c
1
dY dG dT [dCa (1 c)dG dI ]
1 c
dY 1 c
dG dT 1
dG 1 c
Cont,…..
If tax is a (linear) function of income (T = tY):
Y Ca c(Y tY ) I G
dY dCa c[dY d (tY )] dI dG
dY dCa c[dY (tdY Ydt )] dI dG
dY dCa cdY ctdY cYdt dI dG
dY cdY ctdY dCa cYdt dI dG
(1 c ct )dY dCa cYdt dI dG
1
dY [dCa cYdt dI dG ]
(1 c ct )
Cont, …..
If tax is a (linear) function of income (T = tY):
1
dY [dCa cYdt dI dG ]
(1 c ct )
dY dY dY 1
dCa dI dG 1 c ct
The tax rate multiplier:
dY cY
dt 1 c ct
Example:
When the interest rate rises, people want to hold less of their
wealth in the form of money.
(M/P) d = L(r),
cont., ….
The Theory of Liquidity Preference
On these grounds, the demand for real balances
• The supply and demand for real
money balances determine the
rises with Y & decreases with r:
interest rate. The supply curve for
M d real money balances is vertical
( ) kY hr because the supply does not
P depend on the interest rate.
• The demand curve is downward
For a given level of Y, the quantity demanded of
sloping because a higher interest
M/P is a decreasing function of r.
rate raises the cost of holding
money and thus lowers the
Higher Y means larger demand for M/P, &
quantity demanded.
d• At the equilibrium interest rate, the
therefore shifts the (M/P) curve to the right.
quantity of real money balances
(M/P)S & (M/P)d determine what r prevails in the
demanded equals the quantity
supplied.
economy (what r equilibrates the money market).
How money supply affect r?
Income, Money Demand, and the LM Curve
Suppose, when income increases from Y1 to Y2. As panel
(a) illustrates, this increase in income shifts the money
demand curve to the right.
With the supply of real money balances unchanged, the
interest rate must rise from r1 to r2 to equilibrate the money
market.
Therefore, according to the theory of liquidity preference,
higher income leads to a higher interest rate.
The LM curve plots this relationship between the level of
income and the interest rate.
The higher the level of income, the higher the demand for
real money balances, and the higher the equilibrium interest
rate.
For this reason, the LM curve slopes upward, as in panel
(b).
Cont, ….
Income, Money Demand, and the LM Curve
When Y is high, expenditure is high, so people
engage in more transactions that require the use
of money.
The higher Y, the higher (M/P)d will be, and the
higher the equilibrium r.
Therefore, a higher Y leads to a higher r.
The LM curve plots this positive relationship b/n
Y & r.
Cont, ….
1 (1 c) M
r [ (hr ) Ca cT I a G ]
b k P
k (1 c) M
r [Ca I a G cT ]
bk (1 c)h k P
Cont, …
1 M
Y {hr }
k P
1 hk (1 c) M M
Y { [Ca I a G cT ] }
k [bk (1 c)h] k P P
1 hk bk M
Y { [Ca I a G cT ] ( )}
k [bk (1 c)h] [bk (1 c)h] P
h b M
Y [Ca I a G cT ( )]
bk (1 c)h h P
The effect of policy changes
The intersection of the IS & the LM curves determines level of
national income (Y).
When one of these curves shifts, the short-run equilibrium changes
& Y fluctuates.
k (1 c) M
From r [Ca I a G , cT ]
bk (1 c)h k P
k (1 c) dM MdP
dr [dCa dI a dG cdT [ 2 ]
bk (1 c)h k P P
dr dr dr k
0
dCa dI a dG bk (1 c)h
dr ck
0
dT bk (1 c)h
dr (1 c) P 1
0
dM bk (1 c)h
3.1.2.4 Explaining Fluctuations with IS-LM Model
h b M
From Y [Ca I a G cT (, )]
bk (1 c )h h P
h b dM MdP
dY [dCa dI a dG cdT ( 2 )]
(1 c)h bk h P P
dY dY dY h
0
dCa dI a dG (1 c)h bk
dY ch
0
dT (1 c)h bk
dY bP 1
0
dM (1 c)h bk
Effectiveness of both policies…..
Fiscal policy is more effective at influencing Y:
the flatter the LM curve – (M/P)d less sensitive to
Y &/or more sensitive to r, &
the larger the MPC (larger right- or left-ward shift
in IS curve) & the less sensitive I to r (smaller
crowding out effect).
Monetary policy is more effective at influencing Y:
the flatter the IS curve – the larger the MPC & the
more sensitive I to r, &
the less sensitive (M/P)d to r (larger down- or up-
ward shift in LM curve) &/or the less sensitive
(M/P)d to Y.
3.1.2.5 Interaction b/n Monetary & Fiscal Policies
A change in monetary/fiscal policy may influence
the other, & the interdependence may alter the
impact of a policy change.
For example, suppose gov’t raises taxes.
The effect of this policy depends on how the
central bank responds to the tax raise.
The figure below shows three of the many possible
outcomes.
Example:
b -1 h
Y {MP [Ca cT I a G ]}
bk h(1 c) b
Y b M
The slope of AD is: [ 2]
P bk h(1 c) P
P bk h(1 c) P 2
[ ] 0
Y b M
Thank you!
3.2 Aggregate Supply
3.2.1 Introduction to Aggregate Supply
The levels of eqlm output & price that prevail in
an economy depend on AD & AS.
AS describes the amount of output that producers
are willing & able to supply.
The AS curve implicit in IS-LM is based on the
notion of no supply constraints & pre-determined
prices in the short-run.
Whatever output level demanded will be
produced & the AS curve is horizontal.
There is sufficient excess capacity so that AD
production without costs & prices.
At the opposite extreme to the horizontal AS
curve lies the vertical AS curve of classicals.
In this view, each market reaches an eqlm which
determines relative prices & quantity.
3.2.2 Models of Aggregate Supply
The two AS curves are theoretical extremes, do
not depict the real world behavior.
An upward sloping SRAS is more realistic.
4 prominent models of SRAS.
The models differ in some details, but share a
common theme about what makes SRAS & LRAS
curves differ & a common end that SRAS curve is
upward sloping.
In all of them, some market imperfection causes Y
to deviate from the classical benchmark (the
natural rate, ). Y
3.2.2.1 The Sticky-wage Model
Why SRAS curve is upward sloping?
Due to sluggish adjustment of nominal wages.
Nominal wages are set by long-term contracts &
cannot adjust quickly.
Even without formal contracts, implicit agree-
ments b/n workers & firms or social norms &
notions of fairness may limit s in W.
So, nominal wages are sticky in the short run.
1) Workers & firms bargain & agree on nominal
wage (W) before they know what P will be.
They set W based on target real wage (ω) & on
expected price level (Pe): W P e
Y Y (P P ) e
Output deviates from its natural level when P
deviates from Pe.
3.2.2.2 The Worker-Misperception Model
W can adjust freely & quickly to set Ls = Ld.
Unexpected P affects Ls as workers tempo rarily
confuse real & nominal wages.
The 2 components of the model: Ls & Ld.
Ld = Ld(W/P).
Ls = Ls(W/Pe).
Workers know W, but not P: when deciding how
much to work, they consider W/Pe:
W W P
e
e
P P P
P/Pe = workers’ misperception of price level.
If P/Pe > 1, P is greater than what workers
expected & W/P < W/Pe.
Ls = Ls[(W/P) X (P/Pe)].
3.2.2.2 The Worker-Misperception Model
Position of Ls curve & eqlm depend on P/Pe.
When P rises, economy’s reaction depends on
whether workers anticipate the change.
If they do, then Pe rises proportionately with P:
neither Ls nor Ld s; W rises proportionally with
Ps; W/P & emp’t remain the same.
If the P catches workers by surprise, Pe remains
the same when P rises.
The rise in P/Pe shifts Ls to right, lowering W/P &
raising the level of emp’t.
Hence, workers believe that P is lower & thus W/P
is higher than actually is the case.
This induces them to supply more labor.
3.2.2.2 The Worker-Misperception Model
Firms are assumed to be better informed than
workers & to recognize the fall in W/P: they hire
more L & produce more Y.
Deviations of P from Pe induce workers to their
Ls & this s quantity of Y firms produce:
Y Y (P P ) e