blch51 goods and financial markets 1 : is-lm goal: link the goods and the financial markets into a...
TRANSCRIPT
BlCh5 1
Goods and Financial Markets1: IS-LM
• Goal: link the goods and the financial markets into a more general model that will determine the equilibrium and the equilibrium in the economy (with prices)
• The goods market will be represented by the curve (standing for investment-savings) • The financial markets (money market) will be
represented by the curve (liquidity-money)
1. The Hicks-Hansen model based on Keynes’ General Theory
BlCh5 2
The goods market - IS curve• Equilibrium condition
• will provide the link to the financial markets
• Determinants of investment:– If increase, producers
might want to increase their productive capacity by investing in capital goods.
– If , producers find that borrowing to add new capital becomes more expensive
€
I=
BlCh5 3
• Equilibrium in the goods market becomes:Y =
• Basically – When i I and Ye
– When i I and Ye
• The ZZ curve shifts now as the interest rate changes and a multiplier effect takes place– If MPI is the marginal propensity to invest out of new
income, assume that MPC + MPI < 1– The slope of the ZZ curve is now and
the interest rate is included in the intercept
BlCh5 4
Construction of the IS curve
Z
Y
Y
i
Y’e Ye
YeY’e
i
i’
When the interest rate increases, I (Y, i) drops and the ZZ curve shifts down. The economy contracts from Ye to Y’e.
E and E’ correspond to 2 combinations of i and Y, such that the good market is in equilibrium.
i
BlCh5 5
The IS curve• Y = • Definition: All the combinations
i.e. the above equation is satisfied• Shift of the IS: A change in any of the
in the equation will
cause IS to shift.– Shift variables:
• (confidence variables)• (fiscal policy variables)
BlCh5 6
Expansionary fiscal policy: increase in G
Z
Y
Y
i
Ye
Ye
Y=Z
ZZ (G)
i E
IS
When G increases by ∆G, ZZ shifts up and IS shifts to the right.
An increase in T would has the opposite effect as it is contractionary.
BlCh5 7
Shifts of IS
i
Y
IS
GTc0
I0
GTc0
I0
Expansionary
Contractionary
BlCh5 8
The financial markets - LM curve
• Equilibrium condition1:
supply of money = demand for money
Ms = or Ms/P =
(Ms/P is the real money supply)
• It is clear that both LM and IS are relations between i and Y
1. The bonds market is automatically in equilibrium when the
money market is in equilibrium
BlCh5 9
Construction of the LM curve
ii
M/P Y
Ms
Y0 Y1
i0
Md(Y0)
BlCh5 10
The LM curve• Ms = • Definition: All the combinations of and
such that the ( and ) are in equilibrium• Shift of the LM curve: a change in the
money or a change in or an exogenous shift in the money demand – An in the money supply ( or a in price) is expansionary– A change in the velocity of money
BlCh5 11
Expansionary monetary policy: an increase in Ms
A
ii
M/P Y
Md(Y0)
Y0
i0
Ms
LM
BlCh5 12
Shifts of LM
Y
iLM
Ms
PV
Ms
PV
Expansio
nary
Contracti
onary
BlCh5 13
The IS-LM model
Y = IS curveM/P = LM curveIS is sloped and LM is sloped, they will intercept in E
determining Y and i in equilibrium.At that point, all three markets : two financial markets and the goods market,
are
BlCh5 14
The IS-LM graph
i
Y
BlCh5 15
Problem # 4
IS-LM model:
C = 200+ .25YD
I = 150 + .25Y - 1000i
G = 250 and T = 200
(M/P)d = 2Y - 8000i
M/P = 1,600
IS
LM
BlCh5 16
a. Derive the IS curve: Y = C + I + G
Y = 200 + .25Y- .25T + 150 + .25Y - 1000i + 250
= 550 + .5Y - 1000i
Y - .5Y = 550 - 1000i
Y (1 - .5) = 550 - 1000i
Y = [1/.5] (550 -1000i) multiplier = 2
IS curve:Y = 1100 - 2000i
BlCh5 17
b. Derive the LM curve: YL(i) = M/P
2Y - 8000i = 1600
8000i = 2Y - 1600
LM curve: i = Y/4000 - .2
c. Solve IS-LM for equilibrium Y
Y = 1100 -2000i
= 1100 - 2000(Y/4000 - .2)
= 1100 - .5Y + 400
1.5Y = 1500 so Y = 1000
BlCh5 18
d. i = Y/4000 - .2
= 1000/4000 - .2
= .25 - .2 = .05 so i = 5%
e. Replace equilibrium Y and i into C and I
C = 200 + .25*1000 - .25*200 = 400
I = 150 + .25*1000 - 1000*.05 = 350
G = 250
So Y = 400 + 350 + 250 = 1000
BlCh5 19
Fiscal Policy• Instruments: • Curve affected: • Effect:
Expansionary: when (G-T) or G or T
IS shifts to the Contractionary: when (G-T)
or G or T IS shifts to the
BlCh5 20
A fiscal expansion
i
ie
YYe
LM
IS
A
The economy moves along the LM curve from A to A’
BlCh5 21
Mechanics of fiscal expansionGoods market effects
As G Y = too immediatelyThen C= and I = alsoMultiplier effect: at same i, Y reaches a higher level as IS shifts to the right
Financial markets effectsAs Y the demand for money M = and the ward shift in Md results in a i, but this is a movement along the curve to A’.
BlCh5 22
Effect on investment
As i increases, investment is . So there are 2 opposite effects on investment
as Y increases I
as i increases I
It means that the overall expansion due to the increase in G will be by the impact of the increase in the interest rate on investment.
There is some of private investment due to the increase in government spending.
BlCh5 23
Z
Y
Y
i
Ye Y”
Ye
Y=Z
ZZ (G)
i
∆G
IS
LMi
M/P
Ms
Md
i
i’
Y’e
i’
ExpansionaryFiscalPolicy
BlCh5 24
Net effect of increase in G on investment
1. Using investmt functas Y increases I
as i increases I Net effect is ambiguous
2. Using equil condition
as Y increases Sp as G increases (T - G)
Net effect is ambiguous
€
I =
€
I =
BlCh5 25
Problem # 5 cont.
g. A fiscal expansion: G increases to 400
New IS curve: Y = 700 + .5Y - 1000i
Y = [1/.5] (700 - 1000i)
= 1400 - 2000i
Same LM curve: i = Y/4000 - .2
Solve: Y = 1400 - 2000(Y/4000 - .2)
1.5Y = 1800 so Y = 1200
Replace in LM and we get i = .10 or 10%
BlCh5 26
Calculate the corresponding equilibrium for C & IC = 200 + .25Y - .25T = 200 + 300 - 50 = 450I = 150 + .25Y - 1000i = 150 + 300 - 100 = 350Y = C + I + G = 450 + 350 + 400 = 1200Impact of fiscal expansion:
both Y and i increase.C (a function of Y) increases too.I increases when Y increases and decreases when
i increases (ambiguous results overall). With these data, I does not change as the two
effects neutralize each other.
BlCh5 27
Monetary policy• Instrument:
• Curve affected:
• Effect:
Expansionary when Ms increases
LM shifts to the
Contractionary when Ms is cut
LM shifts to the
BlCh5 28
A monetary contraction
LM
IS
i
Y
A
Ye
ie
BlCh5 29
Mechanics of a monetary contraction
• Open market of bonds
• Suppose P=1 constant - so monetary contraction in terms is equivalent to a terms one.
Financial market effects
As Ms drops, i - money market effect.
Goods market effects
As i increases, investment I = I(Y,i) is affected and Y = .
BlCh5 30
Effect on investment
Unambiguous: as Y drops and
i increases,
investment can only .
Note that the money demand will shift to the left as Y drops dampening the extent of the increase in the interest rate on the fall of I and subsequently on the fall of Y.
BlCh5 31
i
M/PY
iMsM’s
IS
LM
Mdi
Ye
A monetary contraction
BlCh5 32
Problem #5 cont.g. Monetary expansion: M/P increases to 1840Same IS curve: Y = 1100 - 2000iNew LM curve: 2Y - 8000i = 1840i = Y/4000 - 1840/8000i = Y/4000 - .23Solve the IS-LM system:Y = 1100 - 2000(Y/4000 - .23)Y = 1100 - .5Y - 4601.5 Y = 1560 so Y = 1040
BlCh5 33
Replace in LM:i = 1040/4000 - .23 so i = .03 or 3% Solve for C and IC = 410 and I = 380A monetary expansion reduces i
and increases YThus C (function of Y) increases and I (function of Y and of i) increases
unambiguously.
BlCh5 34
Policy Mix 1• To maximize the
expansionary (or contractionary) impact on the economy, use both expansionary monetary and expansionary fiscal policy (or both contractionary).
i
Y
IS
LM
Rational:
BlCh5 35
• To dampen the inflationary impact of an expansionary fiscal policy, use at the same time contractionary monetary policy.
i
Y
IS
LM
Policy Mix 2
Rational: