Roadmap

1) MARKET I : GOODS MARKET • goods demand = C + I + G (+NX) = Y = goods supply (set by maximizing firms) • IS curve 2) MARKET II : MONEY MARKET • money demand = Ld(Y, r + πe) = Ms/P = money supply (set by the Fed) • LM curve

IS LM IS-LM EQUILIBRIUM = EQUILIBRIUM IN BOTH MARKETS I and II 2

Goods Market

• IS curve represents the equilibrium in the goods market: (1) • • • Y = C + I + G + NX

Recall the definition of private savings S (hh) = Y – T – C Recall the definition of national savings S = S (hh) + T – G Combining them (2) S=Y–C–G

•

From (1) and (2) th d F d the demand side of th economy can b written as: d id f the be itt S = I + NX

The IS curve is named as it is because it documents the relationship between Investment 3

and Saving (holding NX constant).

Demand side : the IS curve

C is a function of PVLR (Y, Yf, W), tax policy, expectations, etc. I is a function of r, Af, K, and investment tax policy. policy (we will discuss this shortly) y( y) G is a function of government p NX we will model in the last lecture of the course (for the U.S., NX is small) • • • The IS curve relates Y to r. How do interest rates affect Y? As r falls, Investment increases (due to firm profit maximization behavior). p ) Also Consumption increases (substitution effect dominates) 4

IS curve is downward sloping in {r, Y} space.

IS Curve: Graphical Derivation

I curve S curve (Y=Y1) r

r

r*

r*

I,S

Y1

Y

5

IS Curve: Graphical Derivation

I curve S curve (Y=Y1) r

r

S curve (Y=Y2)

IS

r1

r2

I,S

Y1

Y2

Y

An increase in current Y leads to more desired S, S hence the equilibrium r needs to be lower! 6

IS curve

r

r*

r*

IS Y Y

Suppose r is set by the Fed at the level of r* (we will explore this in depth later in the course). For a given r, we can solve for the level of output desired by the demand side of the economy. We represent the demand side of the economy drawn in {r,Y} space as the I-S curve. Why IS? economy, {r Y} I S curve Because the demand side of the economy can be boiled down to I = S (when NX is zero) 7

What shifts the IS curve

What shifts the IS curve to the right? Anything that increases C, I or G (or NX when we model it): • • • • • • • g p higher PVLR g gher C higher expected income or wealth higher conusmer confidence higher PVLR higher C hi higher Tr or lower T (if the Ricardian equivalence fails) higher C f f higher expectations about A higher MPK higher I f higher business confidence higher MPK higher I lower δ or mm, or lower tK lower adjusted user cost of K higher I higher G

g Changes in r WILL NOT cause IS curve to shift (causes movement along IS curve) 8

IS shift: Fall in Consumer Confidence

Imagine S decreases

r I curve S curve (Y=Y1) r

S curve (Y=Y1)

IS

r1 r2

I,S

Y1

Y

An increase in desired S requires r to decrease if Y is unchanged! 9

Money Market

LM curve represents the equilibrium in the money market

The Money Market is in Equilibrium when Ms/P = Ld(Y, r + πe) Ms/P = Real Money Supply Ld(Y r + πe) (Y, = Real Money Demand

The money supply is decided by the Fed and does not change with interest rates What shifts real money supply: M, P What shifts real money demand: Y, πe LM curve is named as it is because it documents the relationship between Liquidity and 10 Money

Money Market Equilibrium

Ms/P

r

Md/P = Ld(Y,πe)

M/P

11

LM Curve: Graphical Derivation

r r0

M0 /P

r r0

Ld(Y0,πe) Y0 Money Market Y

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LM Curve: Graphical Derivation

r r0

M0 /P

r r0 Ld(Y1,πe) Ld(Y0,πe) Y0 Y1

LM(M0)

Y

Money Market

LM curve

An increase i the l l of transaction will increase the interest rate (for given money supply)! A i in h level f i ill i h i (f i l )! 13

What shifts the LM Curve

LM Curve: represents the relationship of Y and r through the money market As Y increases - Ld shifts upwards...