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• IS-LM model
• IS Curve
• LM Curve
• IS-LM Examples
• Fiscal and Monetary policies
• Keynesians vs. Monetarists
IS-LM modelModels short run changes in the GDP
Short run = changes in prices not known
Short-run Production Equilibria (IS curve)Production = Total demand (expenditures)
Short-run Asset Allocation Equilibria (LM curve)
Money demanded = Money supplied
Y
Real iLM
IS
Short Run
Equilibrium
IS
Y
Real i
IS
Excess demand
for goods
Excess supply
of goods
Short-run Asset Allocation Equilibria (LM curve)Money demanded = Money supplied
Y
Real iLM
Excess supply
of money
Excess demand
for money
Short-run Production Equilibria (IS curve) Production = Total demand (expenditures)
LM
IS-LM model
Y
Real GDP
i
Real
Interest
Rate
LM
IS
Short Run Equilibrium
• IS-LM model
• IS Curve
• LM Curve
• IS-LM Examples
• Fiscal and Monetary policies
• Keynesians vs. Monetarists
IS Curve
Y
Real i
IS
Excess demand
for goods
Excess supply
of goods
Short-run Production Equilibria (IS curve) Production = Total demand (expenditures)
A. When Income (Y) increases both Consumption (C) and Private Savings (S)
increase.
B. When real interest rate (i) increases companies’ investments (I) decrease.
C. In equilibrium: Total Demand (ZZ) = Production (Y) = Income (Y)
We will derive IS curve based on these three facts:
I. IS curve FigureII. IS curve Equation
I
Households
Firms
Wages
FINANCIALMARKET
Goods
& Services
MARKET
Rent Interest
ProfitC
S
Factors M.
(Capital Labor)Government
G
BudgetDeficitT
Rest of world
I Ex
Im
BOPDeficit
IS Curve FigureC. In equilibrium: Total Demand (ZZ) = Production(Y) = Income (Y)
Households
Firms
FINANCIALMARKET
Goods
& Services
MARKETGovernment
G
BudgetDeficitT
IS Curve Figure
Budget Deficit = G – T
FINANCIALMARKET
Goods
& Services
MARKET
Rest of world
Ex
Im
BOPDeficit
IS Curve Figure
BOP Deficit = Im – Ex +/- foreign wages, profits,…
Budget Deficit = G – T
I
HouseholdsFINANCIAL
MARKET
Goods
& Services
MARKET
S
TWIN DEFICITS:
(G – T) = S – I + (Im – Ex)
Budget deficit ≈≈≈≈ BOP def.
Government
BudgetDeficit
Rest of world
BOPDeficit
IS Curve Figure
S = I + (G – T) + (Ex – Im)
S = I + G – T + NX
BOP Deficit = Im – Ex +/- foreign wages, profits,…
Budget Deficit = G – T
S = I + G – T + NX
In case of (1) closed economy: NX = 0
(2) balanced budget: T = G
S = I
Private Saving = Investment
Note that if G-T or NX changes then so do S and I
Investment I and Real Interest Rate i (exp.)
B. When real interest rate (i) increases
companies’ investments (I) decrease.
Private Saving S and Income Y
A. When Income (Y) increases both
Consumption (C) and Private Savings (S) increase.
I
S
I
(Real) i
Y
S
IS Curve Figure
S = I + G – T + NX
In case of (1) closed economy: NX = 0
(2) balanced budget: T = G
S = I
Private Saving = Investment
Note that if G-T or NX changes then so do S and I
Investment I and Real Interest Rate i (exp.)
B. When real interest rate (i) increases
companies’ investments (I) decrease.
Private Saving S and Income Y
A. When Income (Y) increases both
Consumption (C) and Private Savings (S) increase.
I
S
I
(Real) i
Y
S
IS Curve Figure
G increases, T decreases(fiscal expansion)
X increases, Im decreases(depreciation=weakening of currency)
Expected Profitability of I increases(less regulation, smaller corp. taxes, …)
Willingness to save increases(consumers scarred,…)
S
I
Real i
Y
LY
Li
Real i
Y
LM curve
Ms = Li +LY
IS curveI
S
I
(Real) i
Y
S
IS Curve Figure
S
I
Real i
Y
LY
Li
Real i
Y
LM curve
Ms = Li +LY
IS curveI
S
I
(Real) i
Y
S
IS Curve Figure
fiscal expansion or depreciation
S
I
Real i
Y
LY
Li
Real i
Y
LM curve
Ms = Li +LY
IS curveI
S
I
(Real) i
Y
S
IS Curve Figure
less regulation, smaller corp.
taxes (with unchanged budget deficit)
S
I
Real i
Y
LY
Li
Real i
Y
LM curve
Ms = Li +LY
IS curveI
S
I
(Real) i
Y
S
IS Curve Figure
consumers scarred