MODELLING THE
ECONOMY IN THE
SHORT RUN (PART 1)
The Goods Market
The Composition of GDP
The Demand for Goods
The Determination of Equilibrium Output
Learning outcome: Determining Equilibrium Output in
the Short Run
THE GOODS MARKET
• When economists think about year-to-year movements in economic
activity, they focus on the interactions among production, income, and
demand:
• Changes in the demand for goods lead to changes in production
• Changes in production lead to changes in income
• Changes in income lead to changes in the demand for goods
THE COMPOSITION OF GDP
• Consumption (C): goods and services purchased by consumers
• Investment (I) or fixed investment (not inventory investment): the
sum of nonresidential investment and residential investment. (new
capital goods)
• Government spending (G): purchases of goods and services by
the federal, state, and local governments; excluding
government transfers
THE COMPOSITION OF GDP
• Exports (X): purchases of a country goods and services by
foreigners
• Imports (IM): purchases of foreign goods and services by a
country consumers, a country firms and the a country government
• Net exports or trade balance: X − IM
!
• Exports > Imports ⇔ trade surplus
!
• Imports > Exports ⇔ trade deficit
• Inventory investment: difference between production and sales
THE COMPOSITION OF GDP
Table 3-1 The Composition of KSA GDP, 2018*
Millions of
Riyals
1
2
3
4
5
GDP (Y)
Consumption (C)
Investment (I)
Government Spending
Net Exports
Exports (X)
Imports (IM)
Inventory Investment (change in stock)
*provisional
Source: Saudi Arabian Monetary Authority
Percent of
GDP
2,949,457
1,118,241
613,385
38%
21%
726,101
25%
390,454
1,176,907
-786,453
13%
40%
-27%
101,278
3%
THE DEMAND FOR GOODS
Demand for goods Z ≡ C + I + G + X − IM
• The above identity defines the total demand for goods (Z) as consumption,
plus investment, plus government, plus export, minus imports.
• In a closed economy (X = IM = 0):
Z≡C+I+G
THE DEMAND FOR GOODS
• Consumption (C) is a function of disposable income (YD), which is the
income that remains once consumers have received government
transfers and paid their taxes.
• C(YD) is called the consumption function.
• This is a behavioral equation that captures the behavior of
consumers.
THE DEMAND FOR GOODS
• Assume that the consumption function is a linear relation with
two parameters, c0 and c1:
• c1 is the propensity to consume.
• c0 is what people would consume if their disposable income equals zero in the
current year.
• Changes in c0 reflect changes in consumption for a given level of
disposable income.
How can people have positive consumption if their income is zero?
THE DEMAND FOR GOODS
Figure 3-1 Consumption and Disposable Income
•
•
•
•
Linear equation: straight line
Intercept: Co
Slope: C1
C1 is <1; slope of line is <1
(flatter than 45 degree line
• Consumption
increases
with
disposable
income but less than one for one.
• A lower value of c0 will shift the entire line
down.
THE DEMAND FOR GOODS
• Disposable income is:
YD ≡ Y − T
where Y is income and T is taxes minus government
transfers.
• Replacing YD in equation (3.2) gives:
THE DEMAND FOR GOODS
• Endogenous variables: variables depend on other variables in
the model (explained within the model)
• Exogenous variables: variables not explained within the model
but are instead taken as given
• A bar on investment means investment is taken as given.
• Investment, for now does not respond to changes in production.
THE DEMAND FOR GOODS
• T and G describe fiscal policy—the choice of taxes and spending by
the government.
• G and T are exogenous because:
• Governments do not behave with the same regularity as
consumer or firms.
• (Typically treat G and T as variables chosen by the government
and we will not try to explain them within the model.)
THE DETERMINATION OF EQUILIBRIUM OUTPUT
• Assume X=IM=0, so
Z≡C+I+G
• Replacing C and I from equations (3.3) and (3.4):
• Equilibrium in the goods markets requires
• This is an equilibrium condition.
Y = Production, and Y also = income.
THE DETERMINATION OF EQUILIBRIUM OUTPUT
• Replacing Z in (3.6) by equation (3.5) gives
• In equilibrium, production (Y) is equal to demand, which in
turn depends on income (Y), which is itself equal to
production.
(If inventories present, production does not have to equal demand)
In equilibrium, for now, we assume no inventories.
THE DETERMINATION OF EQUILIBRIUM OUTPUT
• Macroeconomists always use three tools:
1. Algebra to make sure that the logic is correct
2. Graphs to build the tuition
3. Words to explain the results
THE DETERMINATION OF EQUILIBRIUM OUTPUT
• Rewrite equation (3.7) and Reorganize the equation:
Move c1Y to left
Divide both sides by (1-c1)
This shows the level of
output such that production
equals demand
MPC is c1 between 0 and 1.
(1/1-c1) must be >1. Called the
Multiplier.
(co+I+G-c1T ) is that part of demand that does
not depend on output : autonomous spending
THE DETERMINATION OF EQUILIBRIUM OUTPUT
Is autonomous spending positive? Maybe/maybe not…but likely it is.
• Autonomous spending: [c0 + 𝐼! + G – c1T]
• Autonomous spending is positive because if T = G (balanced budget) and c1 is between 0
and 1, then (G – c1T) is positive, and so is autonomous spending.
Only in a large government surplus would autonomous spending be negative.
• Assume government spend 1billion in the economy. What happen to the output in the
economy?
• The term 1/(1-c1) is the multiplier, which is larger when c1 is closer to 1.
• If c1 equals 0.6, the multiplier equals 1/(1 – 0.6) = 2.5, meaning that an increase of
consumption by $1 billion will increase output by 2.5 x $1 billion = $2.5 billion.
Any change in autonomous spending will change output by more than its
direct effect
THE DETERMINATION OF EQUILIBRIUM OUTPUT
• Steps to characterize the equilibrium graphically:
1. Plot production as a function of income. Because production equals income,
their relation is the 45-degree line, with slope = 1.
2. Plot demand as a function of income. see equation 3.5 below and rewrite:
• Demand depends on:
• (Autonomous spending [c0 + 𝑰! + G – c1T]) and (c1Y) depends on Income
THE DETERMINATION OF EQUILIBRIUM
OUTPUT
Figure 3-2 Equilibrium in the
Goods Market
Equilibrium output is
determined by the condition
that production is equal to
demand.
To the left, Demand > production
To the right, production > demand
THE DETERMINATION OF EQUILIBRIUM OUTPUT
• Suppose c0 increases by $1 billion.
Consumers increase consumption by 1 billion
New equilibrium is A’ and equilibrium
output increases from Y to Y’
Distance between Y and Y’ is greater than
distance between ZZ and ZZ’
An increase in autonomous spending
(co), has a more than one-for-one
effect on equilibrium output.
Figure 3-3 The effects of an increase in
autonomous spending on output
THE DETERMINATION OF EQUILIBRIUM
OUTPUT
• AB: first-round increase in production
• BC: first-round increase in income
• CD: second-round increase in demand
• DE: second-round increase in production and income
• The total increase in production after n+1 rounds equals 1 billion times the sum:
1 + c 1 + c 12 + … + c 1n
which is a geometric series with a limit of 1/(1-c1).
The original increase in demand triggers successive increases in production, with each increase in production
leading to an increase in income, which leads to an increase in demand, which leads to a further increase in
production, which leads…etc. The multiplier is the sum of all these successive increases in production.
• The multiplier illustrates the extent to which equilibrium
output will change as a result of a given change in
autonomous demand.
What is the autonomus cchange in the prevous case?
THE DETERMINATION OF EQUILIBRIUM OUTPUT
• To summarize our findings using words:
• Production depends on demand, which depends on income, which is itself
equal to production.
• An increase in demand leads to an increase in production and income, which
in turn leads to a future increase in demand.
• The increase in output that is larger than the initial shift in demand, by a
factor equal to the multiplier.
• The multiplier depends on the propensity to consume (c1), which can be
estimated using econometrics—the set of statistical methods used in
economics.
THE DETERMINATION OF EQUILIBRIUM OUTPUT
• The adjustment of output over time is called the dynamics of
adjustment.
• How long the adjustment takes depends on how and when firms
revise their production schedule.
•Stop here:
Solve The Problem
C = 100 + 0.8Yd
I = 200
𝐺 = 100
Exercise:
𝑇 = 50 + 0.1𝑦
Given the following system of equations:
1- Find the Equilibrium Output (Y)?
2- Find value of consumption in equilibrium?
3- Find value of saving in equilibrium?
4- Find the production curve ,the demand curve and determine the equilibrium point
and graph them in a diagram?
5- Suppose that the government increase the spending to 150. What is the effect on
the equilibrium? Show the change in your diagram
INVESTMENT EQUALS SAVING: AN ALTERNATIVE
WAY OF THINKING ABOUT GOODS—MARKET EQUILIBRIUM
• John Maynard Keynes articulated an alternative model that focuses instead on
investment and saving in the General Theory of Employment, Interest and
Money in 1936.
• Private saving (S) is
S ≡ YD − C
S≡Y−T−C
• By definition, public saving = T − G.
!
• Positive Public saving > 0 ⇔ Budget surplus (T exceed G)
!
• Negative Public saving < 0 ⇔ Budget deficit (T less than G)
EQUILIBRIUM CONDITION FOR THE GOODS MARKET:
IS RELATION
• In equilibrium: production = demand
Y=C+I+G
• Subtract T from both sides and move C to the left side:
Y − T − C = I + G −T
• The left side of the equation is simply S, so
S = I + G −T
• Or equivalently
• This is the IS relation, which stands for “Investment equals Saving”.
(private (S) and public saving (T-G) )
What firms want to invest must be equal to what people
and the government want to save
INVESTMENT EQUALS SAVING: AN ALTERNATIVE
WAY OF THINKING ABOUT GOODS—MARKET EQUILIBRIUM
• Two equivalent ways of stating the condition for
equilibrium in the goods market:
Production (Y) = Demand (Z)
Investment (I) = Saving (S)
Equilibrium Condition for the goods market: IS relation
• We can also derive equation (3.8)
using equation (3.10)
• Because consumption behavior implies that:
S=Y−T−C
= Y − T − c0 − c1(Y − T )
Rearranging terms, so
• (1−c1) is called the propensity to save, which is between zero and one.
INVESTMENT EQUALS SAVING: AN ALTERNATIVE
WAY OF THINKING ABOUT GOODS—MARKET EQUILIBRIUM
• In equilibrium, I = S, so that equation (3.10) becomes:
I = −c0 + (1 − c1)(Y − T ) + (T − G )
• Solve for output:
which is the same as equation (3.8).
DOES THE GOVERNMENT HAVE INFINITE POWER?
A WARNING
• Equation (3.8) implies that the government can choose the level of G or T to
affect the level of output it wants.
• However, there are many aspects of reality that we have not incorporated in
our model:
• Changing G or T is not easy.
• Investment and imports may change, making it hard for governments to assess the effects
of their policies
• Expectations are likely to matter (tax cuts permanent or not?)
• The effects on output may be unsustainable in the medium run. Inflation
• Cutting T or increasing G can lead to large budget deficits and public debt in the long run
FOCUS:THE PARADOX OF SAVING
• We are told about the virtues of thrift as we grow up, but the model in this chapter tells a
different story.
• Suppose that consumers decide to save more, so c0 decreases.
• Equation (3.12)
implies that output decreases.
• Saving cannot change either, because equation (3.10) implies that at equilibrium:
I = S + (T − G )
• S cannot change because I, T or G does not change by assumption.
THE PARADOX OF SAVING
• The paradox of saving refers to the effects of an increased desire to save on
output and on the final level of saving.
• The increased desire to save is equivalent to a reduction in consumption.
This drop in demand will cause a drop in output.
• Furthermore, in this simple economy, the final level of saving will equal the
initial level of saving.
• So, an increased desire to save has a negative effect on the economy and has
no permanent effect on the level of saving (because S = I in the simple
model).
MODELLING THE
ECONOMY IN THE SHORT
RUN (PART 1)
FINANCIAL MARKET
Coverage
The Demand for Money
Determining the Interest Rate: I
The Liquidity Trap
( Chapter 4 - Olivier Blanchard)
FINANCIAL MARKETS
• Financial markets are terrifying, but they play an essential role in the
economy.
• In this chapter, we focus on the role of the central bank in affecting
interest rates.
• We learn how the interest rate on bonds is determined, and the role of
the central bank (Federal Reserve Bank, or the Fed, in the United
States) in the interest rate determination.
THE DEMAND FOR MONEY
• Suppose you only have a choice between two assets: money and
bonds.
• Money are used for transactions, but it pays no interest.
• Two types of money: currency and checkable deposits.
• Bonds pay a positive interest rate, i (the rate of interest), but
cannot be used for transaction.
THE DEMAND FOR MONEY
• The holding of money and bonds depends on:
• Your level of transactions
• The interest rate on bonds
• You can hold bonds indirectly through money market funds, or money
market mutual funds.
• In the early 1980s, the interest rate on money market funds reached 14%
per year, so people earned more interest by moving their wealth from
checking accounts to these funds.
FOCUS: MONEY, INCOME, AND WEALTH
• Money is what can be used to pay for transactions (flow and a stock).
• Income is what you earn, and it is a flow.
• Saving is the part of after-tax income that you do not spend, and it is also a
flow.
• Savings is the value of what you have accumulated over time.
• Financial wealth, or wealth, is the value of all your financial assets minus all
your financial liabilities, and it is a stock variable
• Investment is what economists refer to as the purchase of new capital goods.
• Financial investment is the purchase of shares or other financial assets.
THE DEMAND FOR MONEY
• Demand for money (Md) is equal to nominal income $Y (a
measure of level of transactions in the economy) times a
decreasing function of the interest rate i:
• An increase in the interest rate decreases the demand for
money, as people put more of their wealth into bonds-Liquidity
function =L(i)
THE DEMAND FOR MONEY
• Equation (4.1) means that the demand for money:
• increases in proportion to nominal income, and
• depends negatively on the interest rate.
• The relation between the demand for money and interest rate for a
given level of income $Y is represented by the Md curve.
THE DEMAND FOR MONEY
For a given level of nominal
income, a lower interest rate
increases the demand for money.
At a given interest rate, an increase
in nominal income shifts the
demand for money to the right.
Figure 4-1 The Demand for Money
FOCUS: WHO HOLDS U.S. CURRENCY
• The amount of currency in circulation in 2006 was $750 billion.
• U.S. households together held $170 billion in currency.
• U.S. firms held another $80 billion.
• Foreigners abroad held $500 billion, or 66% of the total, for transactions,
especially in countries suffering from high inflation in the past.
• The Dollar:The World’s Currency
https://www.cfr.org/backgrounder/dollar-worldscurrency#:~:text=India%2C%20Russia%2C%20Saudi%20Arabia%2C,billion%20worth%20of%20foreign%20
currencies.
DETERMINING THE INTEREST RATE
SUPPOSE JUST CURRENCY EXISTS…(NO CHECKABLE DEPOSITS)
• Suppose the central bank decides to supply an amount of money equal to M:
Ms = M
• Equilibrium in financial markets requires that Ms=Md=M:
i.e., must be such that, given their income ($Y) people are willing to hold an
amount of money equal to the existing money supply
This is called the LM relation. L = liquidity; M = money
Demand for money = demand for liquidity
DETERMINING THE INTEREST RATE
The interest rate must be such
that the supply of money (which
is independent of the interest
rate) is equal to the demand for
money (which does depend on
the interest rate).
The higher i implies
a lower demand for money
Money supply is independent of i
Figure 4-2 The Determination of the Interest Rate
DETERMINING THE INTEREST RATE
Figure 4-3 The Effects of an Increase in Nominal Income on the Interest Rate
Given the money supply, an increase in
nominal income leads to an increase in the
number of transactions, Which increases
demand for money at any interest rate.
So, an increase in nominal income,
increases the interest rate.
At the initial i, the demand for money exceeds
supply.
An increase in i is needed in order to
decrease the amount of money people
want to hold and re-establish a new
equilibrium.
DETERMINING THE INTEREST RATE
Figure 4-4 The Effects of an Increase in the Money Supply on the Interest Rate
An increase in the
supply of money by
the central bank
leads to a decrease
in the interest rate
The decrease in i, increases
demand for money,
so it equals the now larger
money supply
DETERMINING THE INTEREST RATE
• For a given money supply, an increase in nominal income leads to an
increase in the interest rate.
• An increase in the supply of money by the central bank leads to a decrease
in the interest rate.
MONETARY POLICY
• Central banks typically change the supply of money by buying or
selling bonds in the bond market—open market operations.
• Expansionary open market operation: the central bank expands
the supply of money by buying bonds(pays for them by creating
money)
• Contractionary open market operation: the central bank
contracts the supply of money by selling bonds (and removes from
circulation the money it receives for these bonds.)
MONETARY POLICY; BOND PRICES
The assets of the central bank
are the bonds it holds. (The sum
of what the bank owns, and what
is owed to it.)
The liabilities are the stock of
money in the economy. And what
the bank owes to others.
An open market operation in
which the central bank buys bonds
and issues money increases both
assets and liabilities by the same
amount.
Figure 4-5 The Balance Sheet of the Central Bank and the
Effects of an Expansionary Open Market Operation
1-YEAR BONDS..
• Suppose a bond such as a Treasury bill, or T-bill, promises to pay $100 a year from
now.
• If the price of the bond today is $PB, then the interest rate on the bond is:
$100 − $𝑃!
𝑖=
$𝑃!
• Suppose PB = $99; what is i ?
• suppose PB = $90; what is i ?
• The higher the price of the bond, the lower the interest rate.
• The higher the interest rate, the lower the price today.
1-YEAR BONDS..
• If given interest rate, we can figure out the price of the bond
using the same formula. The price of a 1-year bond paying
$100 a year from today is:
$100
$𝑃! =
1+𝑖
• Equal to final payment divided by 1 plus the interest rate.
• If interest rate is (+):
the price of the bond < final payment.
• The higher the interest rate the lower the price today.
• “Bond markets went up today” =
Price of bonds increased; interest rates went down.
RECALL MONETARY POLICY
• Expansionary open market operation: the central bank expands the
supply of money by buying bonds (pays for them by creating money).
• As the central bank buys bonds, demand for bonds increases, increasing
their price.
• Meanwhile, the interest rate on bonds goes down. (note that by paying for
the bonds with money, the central bank has increased the money supply)
RECALL MONETARY POLICY
• Contractionary open market operation: the central bank contracts or
decreases the supply of money by selling bonds (and removes from
circulation the money it receives for these bonds.)
• This decreases the price of bonds and increases the interest rate.
• Note that by selling the bonds in exchange for money previously held by
households, the central bank has reduced the money supply.
SUMMARY
• i is determined when S = D for money.
• By changing supply of money, the Central Bank(CB) can affect i.
• CB changes S of money through open mkt operations (purchases/sales of bonds)
• Open mkt operations in which CB increases the money supply by buying bonds lead to
an increase in the price of bonds and a decrease in the i (purchase of bonds by CB shifts
MS to the right.
• Open mkt operations where CB decreases MS by selling bonds lead to a decrease in the
price of bonds and an increase in i (purchase of bonds by CB shifts MS left).
THE LIQUIDITY TRAP
• Zero lower bound: The interest rate cannot go below zero.
• The economy is in a liquidity trap when the interest rate is
down to zero, monetary policy cannot decrease it further.
THE LIQUIDITY TRAP
Figure 4-8 Money Demand, Money
Supply, and the Liquidity Trap
When the interest rate is equal to zero,
and once people have enough money for
transaction purposes, they become
indifferent between holding money and
holding bonds.
The demand for money becomes horizontal.
This implies that, when the interest rate is
equal to zero, further increases in the
money supply have no effect on the
interest rate, which remains equal to zero.
GOODS AND
FINANCIAL MARKETS
THE IS-LM MODEL
PART A
OUTLINE
Goods and Financial Markets
Road map:
• Introduction
• The goods market: the IS curve
• The financial market: LM curve
• Equilibrium: IS-LM
• Fiscal and monetary policies
HOW ARE OUTPUT AND THE INTEREST RATE
DETERMINED SIMULTANEOUSLY IN THE SHORT RUN?
Output and the interest rate are determined by simultaneous
equilibrium in the goods and money markets.
In the short run, we assume that production responds to demand
without changes in price (i.e., price is fixed), so output is determined
by demand.
WHY THE ANSWER MATTERS
The determination of output is the fundamental issue in macroeconomics.
-The interest rate affects output (through investment) and
-output affects the interest rate (through money demand)
so, it is necessary to consider the simultaneous determination of output and
the interest rate.
GOODS AND FINANCIAL MARKETS:
THE IS-LM MODEL
• Now we look at goods and financial markets together and
understand how output and the interest rate are determined in the
short run.
• Originating from John Keynes contribution, John Hicks and Alvin
Hansen called this framework the IS-LM model.
1. The goods market
1.1. What we remember from goods market
1.2. Investment
1.3. Determining output
1.4. The IS relation
1.5. Shifts of the IS curve
The Goods Market
Demand for goods: C(YD) + I + G
where YD = Y - T is the disposable income
Supply of goods: Y
Equilibrium: Y = C(Yd) + I + G
INVESTMENT
• In the first model we developed, investment was assumed to be constant for simplicity. (now
relax the assumption and now assume that investment is endogenous).
• In fact, investment is far from constant and depends on production Y (or sales) and the
interest rate i.
• I depends on Production Y, and the interest rate i. (assume inventory investment =0), so sales and
production are equal.
• As a result Y = sales and Y = production.
• The positive sign under Y indicates an increase in production (sales) leads to an increase in I.
• The negative sign under i indicates an increase in i leads to a decrease in I.
THE GOODS MARKET AND THE IS RELATION
What happens to output when i changes
For a given value of i, The demand for goods is
an increasing function of output for 2 reasons:
1.↑ output → ↑ income→
↑ disposable income → ↑ C
2. ↑ output → ↑ I (Investment and production)
Thus an
↑ output → ↑ Demand for goods.
In short, an increase in output leads, through its effects on
both consumption and investment, to an increase in the
demand for goods.
Equilibrium requires that the demand for goods be
equal to output.
Figure 5-1 Equilibrium in the Goods Market
EQUILIBRIUM IN GOODS MARKET
• Equilibrium in the goods market is determined by the effect of interest rates on
investment.
• Starting with the definition of GDP for a closed economy (ignoring the trade account),
Y=C+I+G
• Cd = f(Y –T, r ) where the relationship between Cd and Y is positive and between Cd
and r is negative. Why?
• Id = I(r) where the relationship is negative. Why?
Note: since the model assume there is no change in price or inflation, then i=r. Hence,
we use i and r interchangeably.
THE GOODS MARKET AND THE IS RELATION
IS relation
The IS curve è r=f(Y)
represents all combinations of income (Y) and the real interest rate (r)
such that the market for goods and services is in equilibrium. That is,
every point on the IS curve is an income/real interest rate pair (Y, r)
such that the demand for goods is equal to the supply of goods (where
it is implicitly assumed that whatever is demanded is supplied) or,
equivalently, desired national saving is equal to desired investment.
THE GOODS MARKET AND
THE IS RELATION
(a) An increase in the interest rate i to i’
decreases the demand for goods and
investment at any level of output, (ZZ to
ZZ’) leading to a decrease in the
equilibrium level of output, A to A’ .
(b) New Equilibrium is Y’.
Equilibrium in the goods market
implies that an increase in the interest
rate leads to a decrease in output.
The IS curve is therefore downward sloping.
The increase in i decreases investment. This
investment decrease leads to decrease in output,
which further decreases consumption and
investment through the multiplier effect.
Figure 5-2 The Derivation of the IS Curve
Equilibrium output associated with
any interest rate
Demand curve = ZZ
Initial Equil: A
Equilibrium and the interest rate
PROPERTIES OF IS CURVE
• Downward Sloping,
i­ Þ C¯ Þ Y¯ (why?)
} Y*¯
i­ Þ I¯ Þ Y¯ (why?)
} Increase (Decrease) in autonomous expenditure will shift the IS curve
Rightward (Leftward).
• The steepness or flatness of the IS curve describes the elasticity or
responsiveness of C and I to the nominal interest rate.
-- Steep IS curve: inelastic.
-- Flat IS curve: elastic.
The more sensitive goods demand (C+I+G) is to income relative to the interest rate
(through investment), the steeper the IS curve.
THE GOODS MARKET AND THE IS
RELATION
Figure 5-3 Shifts of the IS Curve: changes in T or G
The downward sloping IS
curve gives the equilibrium
level of output as a function of
the interest rate.
An increase in taxes shifts the
IS curve to the left.
At a given i, the equilibrium
level of output is lower than it
was before the increase in
taxes.
What happens if taxes increase?
• Disposable income drops, consumption drops, demand
drops
• Supply must drop too to maintain the equilibrium.
• For any level of interest rate, the corresponding level of
equilibrium output is now lower
è leftward shift of the IS curve.
What happens if T ↓?
If G ↑?
Exercise
Shift of IS curve
• Any change (decrease in government consumption, increase in
taxes, decrease in consumer confidence - proxied by c0) that, for a
given interest rate, decreases the demand for goods creates a shift
of the IS curve to the left.
• Symmetrically, any change (increase in government consumption,
decrease in taxes, increase in consumer confidence - proxied by c0)
that, for a given interest rate, increases the demand for goods
creates a shift of the IS curve to the right.
THE GOODS MARKET AND THE IS RELATION
• Downward-sloping IS curve:
Equilibrium in the goods market implies that an increase in the
interest rate leads to a decrease in output.
• Shifting the IS curve:
Changes in factors that decrease (increase) the demand for
goods, given the interest rate, shift the IS curve to the left (right).
2. The Financial market
2.1. The LM relation
2.2. Shifts of the LM curve
FINANCIAL MARKETS AND THE LM RELATION
• Recall M = $Y L(i)
(M= Nominal money stock, for now, think of the central bank (CB) controlling M directly)
• Rewrite the above as a relation among REAL money (money in terms of goods) and REAL
income (income in terms of goods) and the interest rate.
• Nominal income divided by P è real income. So, divide both sides of the equation by the
price level P:
LM relation
• In equilibrium, real money supply equals the real money demand, which depends on real
income (output) Y, and the interest rate i.
• Real example: buying coffee in terms of goods, or buying coffee in terms of coins
If income increases, the demand
for money increases at any given
interest rate. Given that the
supply of money is fixed, the
interest rate must increase to
lower the demand for money
and maintain the equilibrium. ,
è Increasing relation between
the interest rate and output.
DERIVING THE (UPWARD) LM CURVE
To see the relationship between output and the interest rate
Equilibrium point A,
where Md = Ms, at interest rate i
Y­ (Y to Y’) Þ Md ­ at any i Þ
Md shifts up Þ i ­ why?
So, we get the relationship of
i=f(Y) à upward sloping LM
curve
DERIVING THE (UPWARD) LM CURVE
• An increase in income leads, at a given interest rate, increases the
number of transactions in the economy. The demand for
money(Md curve) shifts right as:
• Given the (set) money supply, demand for money increases, but Ms is
given (still the same), thus there’s an increase in the equilibrium interest
rate until the two opposite effects on demand for money cancel each
other out i.e.
ü ↑income = people want to hold more money
ü (as bonds will be sold, P of bonds falls, and i increases)
ü ↑i = people want to hold less money
• At this point D for money = unchanged Ms
LM CURVE
Left graph shows the value of i associated with any value of income (for a given Ms)
Right graph shows the equilibrium A corresponds to equilibrium in A on left graph (same for A’)
Equilibrium in the financial markets implies that an increase in
income leads to an increase in the interest rate. New equilibrium
A’. The LM curve is therefore upward sloping.
PROPERTIES OF LM CURVE
• Upward sloping,
• Increase (Decrease) in the real money supply shift the LM curve
Rightward (Leftward).
• The steepness or flatness of the LM curve describes the elasticity or
responsiveness of money demand (L) to the nominal interest rate.
-- Steep LM curve: inelastic.
-- Flat LM curve: elastic.
• With respect to the slopes, the more sensitive money demand is to income relative to the interest
rate, the steeper the LM curve.
SHIFTS IN LM CURVE DUE TO CHANGE IN
MONEY SUPPLY
• Real money supply: M/P
• An increase in M money (nominal money) M
to M’ causes the LM curve to shift down to
the right (as P level is fixed)
At a given level of income, say
Y, the i is lower, i to i’
What happens if the nominal money supply increases?
• Real money supply goes up
• Demand for money should go up too, to maintain
equilibrium: the interest rate must decrease
• For any level of output, the corresponding level of interest
rate is now lower ,è downward shift of the LM curve
FINANCIAL MARKETS AND THE (UPWARD) LM
RELATION
• IS relation: Y = C(Y−T) + I(Y,i) + G
• LM relation:
• The IS and LM relations together determine output and i.
• Any point on the downward sloping IS curve corresponds to
equilibrium in the goods market.
• Any point on the upward sloping LM curve corresponds to
equilibrium in financial markets.
• Only at their intersection (point A) are both equilibrium
relations satisfied.
FACTORS THAT SHIFT THE LM CURVE:
• Nominal money supply: Increase in nominal money supply increases real money supply
lowering the real interest rate that clears the money market. As a result, LM curve shifts down.
Similarly, the LM curve shifts up when nominal money supply decreases.
• Price level: An increase in price level lowers the real money supply rate raising the interest
rate that clears money market. As a result, LM curve shifts up. Similarly, decrease in price level
shifts LM down.
• Expected inflation: As the expected inflation rate rises, people’s holding money rises as to
demand products increase now. In summary, as expected inflation rises, the demand for money
rises.
GOODS AND
FINANCIAL MARKETS
THE IS-LM MODEL
PART B
3. The IS-LM model
3.1. An equilibrium concept
3.2. Fiscal policy
3.3. Monetary policy
3.4. Fiscal and monetary policies
3.5. Policy mix
IS-LM Model: Equilibrium Concept
IS relation:
the supply of goods must be equal to the demand for goods
LM relation:
the supply of money must be equal to the demand for money
TWO – MARKET EQUILIBRIUM
• The intersection point
of the IS and LM curve
denotes the equilibrium
point between the two
markets.
• There is only one
combination of Y and r at
which both the goods
market and the money
market are in equilibrium
simultaneously.
•
•
Equilibrium in goods market implies
an increase in i leads to ↓output.
Equilibrium in financial market
implies an increase in output leads
to ↑i
IS-LM Model: Fiscal Policy
• Fiscal contraction (or fiscal consolidation): decrease in the
budget deficit G – T decrease in government spending increase
in taxes
• Fiscal expansion: increase in the budget deficit G – T
increase in government spending decrease in taxes
IS-LM Model: Fiscal Policy
What happens when taxes increase?
• Leftward shift of the IS curve. Why?
• No shift of the LM curve. Why?
• The increase in taxes shifts the IS curve. The LM curve does not
shift, the economy moves along the LM curve.
What happens if taxes increase?
• Disposable income drops, consumption drops, demand drops
• Supply must drop too to maintain the equilibrium.
• For any level of interest rate, the corresponding level of equilibrium
output is now lower
èleftward shift of the IS curve.
NB: The decrease in output is limited by the positive effect of a decrease in the interest rate on
investment (even though we don’t know if investment increases or decreases).
• Any change (decrease in government
consumption, increase in taxes, decrease in
consumer confidence - proxied by c0) that, for
a given interest rate, decreases the demand
for goods creates a shift of the IS curve to the
left.
• Symmetrically, any change (increase in
government consumption, decrease in taxes,
increase in consumer confidence - proxied by
c0) that, for a given interest rate, increases the
demand for goods creates a shift of the IS
curve to the right.
Explain what are actually happen to the
economy moving from A to D and to A’.
A to D:
Consumption goes down, leading to a decrease in
output/income at the existing interest rate, i.
A to A’:
A decrease in income reduces the demand for money. Given
that the supply of money is fixed, the interest rate must
decrease to push up the demand for money and maintain the
equilibrium in the money/financial market (movement along
the LM curve)
D to A’:
A decrease in interest rate causes C or/and I to increase and
causes an increase in the output from at point D to poit A’
at Y’.
Figure: The effects of an increase in taxes
The decrease in interest rate lower the adverse effect of the taxes on the output/income.
IS-LM Model: Monetary Policy
Monetary policy:
Monetary contraction (or monetary tightening): decrease in the
money supply
Monetary expansion:
increase in the money supply
What happens when the money supply increases?
• No shift of the IS curve. Why?
• Downward shift of the LM curve. Why?
• The increase in money supply shifts the LM curve. The IS
curve does not shift, the economy moves along the IS
curve.
When money supply increases:
• To maintain the equilibrium, the demand for money should go
up. For that to happen, the interest rate must decrease.
• The decrease in the interest rate favor investment, demand for
goods and equilibrium output.
NB: The decrease in the interest rate is limited by the positive effect
of an increase in output on investment, and therefore on output.
An Increase in Money Supply
A to A’
• Ms increases causes Ms/P becomes
higher. It causes the interest rate in
money market to drop and causes the
LM to shift right.
• The decrease in the interest rate
favors investment, demand for goods,
and equilibrium output. This causes
the movement along the IS curve
from A to A’.
Figure: The effects of an increase in money supply
FISCAL AND MONETARY POLICIES
• Fiscal contraction, refers to fiscal policy that reduces the budget
deficit.
• An increase in the deficit is called a fiscal expansion.
• Taxes affect the IS curve, not the LM curve.
• Monetary contraction, refers to a decrease in the money supply.
• An increase in the money supply is called monetary expansion.
• Monetary policy does not affect the IS curve, only the LM curve.
• For example, an increase in the money supply shifts the LM curve down.
BEHAVIORAL PARAMETERS, THE SLOPES OF THE IS
AND LM CURVES, AND POLICY EFFECTIVENESS
• It is worth noting that the slopes of the IS curve and the LM curve do have policy
implications.
• With respect to the slopes, the more sensitive money demand is to income relative to
the interest rate, the steeper the LM curve.
• Likewise, the more sensitive goods demand (C+I+G) is to income relative to the
interest rate (through investment), the steeper the IS curve.
USING A POLICY MIX
• Monetary-fiscal policy mix is the combination of monetary and
fiscal policies.
• Suppose that the economy is in a recession and output is too low.
• Both fiscal and monetary policies can be used to increase output.
The combination of monetary and
fiscal policies is called the
policy mix.
Bigger impact on output
Allows a change in the output level
without a too large change in the
interest rate.
https://www.investopedia.com/articles/economics/08/pastrecessions.asp (the series of recessions in USA in brief)
What abou KSA?
Figure: The policy mix against the recession of 2001
(dot com bubble collapsed)
EFFECTS OF FISCAL AND MONETARY
POLICY
THE EFFECTIVENESS OF POLICY
• Consider an increase in government spending:
• For any given interest rate, the effect of fiscal policy on output will depend on
the multiplier.
• The larger the multiplier, i.e., the greater the sensitivity of consumption
and investment to output, the larger the initial response of output.
•
Since an increase in G will increase Y, it will also increase the quantity of
money demanded for any interest rate (shift the money demand curve up), and
thus increase the interest rate, in order to maintain money market
equilibrium.
FISCAL POLICY
• If money demand is not very sensitive to income, then the excess demand for money
created by the increase in G will be small.
• If money demand is very sensitive to the interest rate, the increase in the interest rate
needed to restore equilibrium in the money market will be small.
• The increase in the interest rate will tend to reduce investment and thus offset some of the
initial increase in output. This effect will be small to the extent that investment is not very
sensitive to the interest rate.
• In sum, fiscal policy will have a greater effect on output if
• the multiplier is large
• money demand is not very sensitive to income
• money demand is very sensitive to the interest rate
• investment is not very sensitive to the interest rate
• Discuss using flow and diagram
MONETARY POLICY
• An increase in the money supply affects output by reducing the interest rate and
increasing investment.
• The change in the money supply will tend to have a large effect on output
• when money demand is not very sensitive to the interest rate, an increase in
money supply will cause the interest will drop a lot.
• Why?
The interest rate will have a large effect on output
• when investment is very sensitive to the interest rate.
• Why?
MONETARY POLICY
• The increase in output increases the quantity of money demanded for any interest rate and
tends to increase the interest rate, offsetting some of the initial effect of the increase in the
money supply.
• This effect will be small when the demand for money is not very sensitive to income.