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Partha Chatterjee, FMS, University of Delhi

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So far…

**Goods market Market for money and bonds Next:
**

We will combine those two Study IS-LM model Talk about Fiscal and Monetary Policy

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In the simple model developed earlier. Y. is equal to the demand for goods.The Goods Market and the IS Relation Equilibrium in the goods market exists when production. Z. the interest rate did not affect the demand for goods. This condition is called the IS relation. The equilibrium condition was given by: Y C(Y T ) I G 3 .

we capture the effects of two factors affecting investment: The level of sales (+) The interest rate (-) I I (Y . Sales. and the Interest Rate Here. i ) ( . ) 4 .Investment.

the equilibrium condition in the goods market becomes: Y C(Y T ) I (Y .Determining Output I I (Y . ) Taking into account the investment relation above. i ) G 5 . i ) ( .

6 . An increase in output also leads to an increase in investment. demand is an increasing function of output.Determining Output For a given value of the interest rate i. for two reasons: An increase in output leads to an increase in income and also to an increase in disposable income.

7 . 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.

8 . ZZ is drawn flatter than a 45-degree line because it’s assumed that an increase in output leads to a less than one-for-one increase in demand. ZZ is. a curve rather than a line. in general.The Determination of Output Note two characteristics of ZZ: Because it’s not assumed that the consumption and investment relations are linear.

9 .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 is downward sloping. 10 .Deriving the IS Curve The Derivation of the IS Curve Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output.

This relation between the interest rate and output is represented by the downward –sloping curve. 11 .Deriving the IS Curve Using the last slide. or IS curve. The interest rate i implies a level of output equal to Y. Panel (b) plots equilibrium output Y on the horizontal axis against the interest rate on the vertical axis. we can find the relation between equilibrium output and the interest rate. Panel (a) reproduces the figure in the last slide.

12 .Example: Shifts of the IS Curve – due to Tax Shifts of the IS Curve An increase in taxes shifts the IS curve to the left.

Shifts of the IS Curve Let’s summarize: Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output. Changes in factors that decrease the demand for goods. given the interest rate shift the IS curve to the left. 13 .

Financial Markets and the LM Relation The interest rate is determined by the equality of the supply of and the demand for money: M $YL(i ) M = nominal money stock $YL(i) = demand for money $Y = nominal income i = nominal interest rate 14 .

and the interest rate. Real Income. the real money supply is equal to the real money demand. and the Interest Rate The LM relation: In equilibrium. Y. which depends on real income.Real Money. i: M YL(i ) P Recall that Nominal GDP = Real GDP multiplied by the GDP deflator: $Y YP Equivalently: 15 $Y Y P .

Given the money supply.Deriving the LM Curve The Effects of an Increase in Income on the Interest Rate An increase in income leads. to an increase in the demand for money. 16 . at a given interest rate. this leads to an increase in the equilibrium interest rate.

17 .Deriving the LM Curve The Derivation of the LM Curve Equilibrium in financial markets implies that an increase in income leads to an increase in the interest rate. The LM curve is upwardsloping.

18 . This curve is called the LM curve.Deriving the LM Curve From the figure we learn: Panel (b) plots the equilibrium interest rate i on the vertical axis against income on the horizontal axis This relation between output and the interest rate is represented by the upward-sloping curve in Panel (b).

19 .Ex: Shifts of the LM Curve – due to changes in real money Shifts of the LM Curve An increase in money leads the LM curve to shift down.

which increases the demand for money. a decrease in the money supply shifts the LM curve up. 20 . leads to an increase in the interest rate.Shifts of the LM Curve Let’s summarize: Equilibrium in financial markets implies that. for a given real money supply. an increase in the level of income. An increase in the money supply shifts the LM curve down.

IS curve: from the goods market equilibrium condition express Y as a function of i (or vice-versa) LM curve: from the financial market equilibrium condition express Y as a function of i (or vice-versa) 21 . IS is for the goods market & LM is for the financial market.Remember Both IS and LM curves represent relations between Y & i.

LM relation: M YL(i ) P 22 . both goods and financial markets are in equilibrium. i ) G The IS-LM Model Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output. Equilibrium in financial markets implies that an increase in output leads to an increase in the interest rate. When the IS curve intersects the LM curve.Putting the IS and the LM Relations Together IS relation: Y C(Y T ) I (Y .

not the LM curve. Taxes affect the IS curve.Fiscal Policy. or fiscal consolidation. refers to fiscal policy that reduces the budget deficit. and the Interest Rate Fiscal contraction. 23 . An increase in the deficit is called a fiscal expansion. Activity.

24 . and the Interest Rate The Effects of an Increase in Taxes An increase in taxes shifts the IS curve to the left.Fiscal Policy. Activity. and leads to a decrease in the equilibrium level of output and the equilibrium interest rate.

Tax cut and Economic Growth Can tax cut spur economic growth? 25 .

only the LM curve. an increase in the money supply shifts the LM curve down. Activity. or monetary tightening. Monetary policy does not affect the IS curve. An increase in the money supply is called monetary expansion.Monetary Policy. 26 . and the Interest Rate Monetary contraction. For example. refers to a decrease in the money supply.

Activity. 27 .Monetary Policy. and the Interest Rate The Effects of a Monetary Expansion Monetary expansion leads to higher output and a lower interest rate.

or simply. Shift of IS Shift of LM Movement of Output Movement in Interest Rate Increase in taxes Decrease in taxes Increase in spending Decrease in spending Increase in money 28 left right right left none none none none none down down up up down up down up up down down Decrease in money none up down up . the policy mix.Using a Policy Mix The combination of monetary and fiscal polices is known as the monetary-fiscal policy mix. The Effects of Fiscal and Monetary Policy.

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