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• LM Curve
• IS-LM Examples
• Fiscal and Monetary policies
• Keynesians vs. Monetarists
• IS-LM Examples
People are worried and thus
1. they want to save more and spend less
2. they want to spend money slower
Profitability of investments decrease and thus 3. firms want to invest less
and savers want to invest less at home
4. currency depreciates (looses value)
IS curve
S
I
Real i
Y
LY
Li
Real i
Y
LM curve
S = I + G – T + NX Ms/P = Li +LY
LMIS
S
I
Real i
Y
LY
Li
Real i
Y
S = I + G – T + NX Ms/P = Li +LY
LMIS
1. PEOPLE WANT TO SAVE MORE
Real GDP
Real
interest
rate
IS1
IS0
LM0
E1
E0
People want to ↑↑↑↑ S
S
I
Real i
Y
LY
Li
Real i
Y
S = I + G – T + NX Ms/P = Li +LY
LMIS
2. VELOCITY OF MONEY DECREASES
Real GDP
Real
interest
rateLM1
IS0
LM0
E0
Velocity of M ↓↓↓↓
E1
S
I
Real i
Y
LY
Li
Real i
Y
S = I + G – T + NX Ms/P = Li +LY
LMIS
3. SMALLER PROFITABILITY OF INVESTMENTS
Real GDP
Real
interest
rate
IS1
IS0
LM0
E1
E0
Smaller Profitability of I
S
I
Real i
Y
LY
Li
Real i
Y
S = I + G – T + NX Ms/P = Li +LY
LMIS
4. CURRENCY DEPRECIATION (NX↑↑↑↑)
Real GDP
Real
interest
rate
IS0
IS1
LM0
E0
E1
Currency Depreciation
People are worried and thus
1. they want to save more and spend less
Y ↓ + i ↓
2. they want to spend money slower
Y ↓ + i ↑
Profitability of investments decrease and thus 3. firms want to invest less
Y ↓ + i ↓
and savers want to invest less at home
4. currency depreciates (looses value)
Y ↑ + i ↑
People are worried and thus
1. they want to save more and spend less
Y ↓ + i ↓
2. they want to spend money slower
Y ↓ + i ↑
Profitability of investments decrease and thus 3. firms want to invest less
Y ↓ + i ↓
and savers want to invest less at home
4. currency depreciates (looses value)
Y ↑ + i ↑
• LM Curve
• IS-LM Examples
• Fiscal and Monetary policies
• Keynesians vs. Monetarists
FISCAL Policy MONETARY Policy
S
I
Real i
Y
LY
Li
Real i
Y
LMIS
(G-T) ↑ : EXPANSION : Ms↑
increases Y
(G-T) ↓ : CONTRACTION : Ms↓
decreases Y
S
I
Real i
Y
LY
Li
Real i
Y
S = I + G – T + NX Ms/P = Li +LY
LMIS
FISCAL EXPANSION
Real GDP
Real
interest
rate
IS0
IS1
LM0
E0
E1
Fiscal Expansion
S
I
Real i
Y
LY
Li
Real i
Y
S = I + G – T + NX Ms/P = Li +LY
LMIS
MONEARY EXPANSION
Real GDP
Real
interest
rate
LM1
IS0
LM0
E1
E0
Monetary Expansion
• LM Curve
• IS-LM Examples
• Fiscal and Monetary policies
• Keynesians vs. Monetarists
Md / P = real money demand is determined by
Transactions motive — positively related to YPrecautionary motive — positively related to YSpeculative motive — negatively related to i
In equilbrium: Ms / P = Md / P = Li + LY
i
Li
Md= f(i, Y)
P – +
Keynes
Liquidity trap
How do Monetarists differ from Keynesians:
Other assets besides money and bonds: equities and real goods
rm
not constant: e.g. if rb
↑, rm
↑, then rb
– rm
may stay unchanged,
and so Md
stays almost unchanged:
Interest rates may have little effect on Md
Md= f(YP, rb – rm, re – rm, πe – rm)
P + – – –
i i
Li Li
Md= f(i, Y)
P – +
Modern Quantity TheoryKeynes
FRIEDMANLiquidity trap
Keynesians vs. Monetarists
KEYNES FRIEDMAN
Liquidity trap
Li
i
Li
i
LMLM
Keynesians and the Liquidity Trap
Y
Real i LM1IS0
E0 = E1
Short Run
Equilibrium
E1
Short Run
Equilibrium
LM0
Y
Real i IS0 LM0IS1
LM curve has
a flat part, thus
an increase of Ms,
that shifts LM
to the right,
does not have any
impact on GDP.
On the other hand,
Fiscal policy
Expansion works
great. Since it has a
limited impact on
interest rates, I is
not crowded out.
Monetarists
Y
Real i LM1IS0
E1
Short Run
Equilibrium
E1
Short Run
Equilibrium
LM0
Y
Real i IS0 IS1
LM curve is steep,
thus an increase of Ms
increases GDP.
On the other hand,
Fiscal policy Expansion
does not work – Since it
only increases
the interest rate,
an increase of
government purchases
results in private
investment I
being crowded out by it.
LM0
Keynesians vs. Monetarists
Y
Real i IS0 LM0IS1
Y
Real i IS0 IS1 LM0
Fiscal expansion works great. It is not worth the debt or it does not work at all !!!
(as i and I do not change) (as i increases and G crowds-out I )
Y
Real i LM1IS0 LM0
Monetary expansion may not work! It does work, but…
(as i and I do not change) …only temporary (before inflation comes)
Y
Real i LM1IS0
LM0
• Fiscal and Monetary policies
• Keynesians vs. Monetarists
• Spending Multipliers
Problem (Multiplier - Fiscal policy)
(a) Suppose that the economy is characterized by the following equations:
C = c0
+ c1
YD
; G , T , NX = constants and I = constant
Solve for equilibrium output and the value of the multiplier.
(b) Suppose that the economy is characterized by the following equations:
C = c0
+ c1
YD
; G , T , NX = constants and I = b0
+ b1
Y – b2
i
Where b1
+c1
<1. Solve for equilibrium output and the value of the multiplier.
(c) Suppose that the economy is characterized by the following equations:
C = c0
+ c1
YD
; G , T , NX = constants and I = b0
+ b1
Y – b2
i
Where b1
+c1
<1. Suppose also that the LM relation is:
Ms / P = d1
Y – d2
i
Solve for equilibrium output and the value of the multiplier.
Problem (Multiplier - Fiscal policy)
(a) Suppose that the economy is characterized by the following equations:
C = c0
+ c1
YD
; G , T , NX = constants and I = constant
Solve for equilibrium output and the value of the multiplier.
(b) Suppose that the economy is characterized by the following equations:
C = c0
+ c1
YD
; G , T , NX = constants and I = b0
+ b1
Y – b2
i
Where b1
+c1
<1. Solve for equilibrium output and the value of the multiplier.
(c) Suppose that the economy is characterized by the following equations:
C = c0
+ c1
YD
; G , T , NX = constants and I = b0
+ b1
Y – b2
i
Where b1
+c1
<1. Suppose also that the LM relation is:
Ms / P = d1
Y – d2
i
Solve for equilibrium output and the value of the multiplier.
Problem (Multiplier - Fiscal policy)
(a) Suppose that the economy is characterized by the following equations:
C = c0
+ c1
YD
; G , T, NX = constants and I = constant
Solve for equilibrium output and the value of the multiplier.
Solution (a)
Z = c0
+ c1
(Y –T) + G + I + NX = Y
Y = 1/(1 – c1
) [ c0
+ c1
(–T) + G + I + NX ]
= multiplier
Solution (a)
Z = c0
+ c1
(Y –T) + G + I + NX = Y
Y = 1/(1 – c1
) [ c0
+ c1
(–T) + G + I + NX ]
= multiplier
Problem (Multiplier - Fiscal policy)
(b) Suppose that the economy is characterized by the following equations:
C = c0
+ c1
YD
; G , T , NX = constants and I = b0
+ b1
Y – b2
i
Where b1
+c1
<1. Solve for equilibrium output and the value of the multiplier.
Solution (b)
Z = c0
+ c1
(Y –T) + G + b0
+ b1
Y – b2
i + NX = Y
Y = 1/(1 – c1
– b1) [ c
0+ c
1(–T) + G + b
0 – b
2i + NX ]
= multiplier (parameter of business confidence
increases multiplier)
… => Bussines cycle has bigger ups and downs
Problem (Multiplier - Fiscal policy)
(c) Suppose that the economy is characterized by the following equations:
C = c0
+ c1
YD
; G , T , NX = constants and I = b0
+ b1
Y – b2
i
Where b1
+c1
<1. Suppose also that the LM relation is given by:
Ms / P = d1
Y – d2
i
Solve for equilibrium output and the value of the multiplier.
Solution (b)
Z = c0
+ c1
(Y –T) + G + b0
+ b1
Y – b2
i + NX = Y
Y = 1/(1 – c1
– b1) [ c
0+ c
1(–T) + G + b
0 – b
2i + NX ]
= multiplier (parameter of business confidence
increases multiplier)
Solution (c)
Z = c0
+ c1
(Y –T) + G + b0
+ b1
Y – b2
i + NX = Y
Y = 1/(1 – c1
– b1
+ b2
d1
/ d2
)[ c0
– c1T + G + b
0 + b
2Ms / (d
2P) + NX ]
{INVESTMENTS are crowded-out}
= multiplier (parameter b2
decreases multiplier)
(parameter (d1
/d2) decreases multiplier)
Z = c0
+ c1
(Y –T) + G + b0
+ b1
Y – b2
( d1
Y – Ms / P ) / d2
+ NX = Y
=> i = – Ms / (d2
P) + ( d1
/ d2
)Y