Macroeconomic equilibrium in the real and in the monetary sector: The IS-LM model Frederick University 2014
Dec 31, 2015
Macroeconomic equilibrium in the real and in the monetary sector:The IS-LM model
Frederick University
2014
Macroeconomic equilibrium in the money market
i
M/P
MS
MD1
i1
i
YY1
i1
Y2
MD2
i2
LM
Income rises and MD increases The equilibrium interest rate increases
LM – curve of the equilibrium on the money sectorOn each point of the curve MS = MD
Analysing the LM curveThe slope of the curve depends on the EMD as regard
Yi
y
LMThe slope of the LM curve depends on The elasticity of MD as regard income and onThe elasticity of MD as regard interest rate
If the Ey is high and the Ei is low, the curve is steep
Analysing the LM curve
i
Y
LM A
All the points on LM present an equilibriumon the money market (MS = MD) and show what should the interest rate (i) beat the given level of income (Y), so that MS = MD
If the economy is in point A, thei is too low for the given y. At this low interest rate the public will wantto hold more liquidity. MD > MS. Therefore, they will start selling their bonds in order to get more liquidity.The supply of bonds will increase and the interest rate will rise.
i1
y1
A’
Factors, determining LM
MSi
M/P
MS1
MD
MS2
i1
i2
i
Y
LM1
i1
Y
i2
LM2
MS increase and the equilibrium interest rate falls. At the same level of income, MS = MD at a lower interest rate. LM shifts to the right
A1
A2
Factors, determining LM
MDi
M/P
MS
MD1
MD2
i1
i2
i
Y
LM1
i1
Y
i2
LM2
MD increase and the equilibrium interest rate rises. At the same level of income, MS = MD at a higher interest rate. LM shifts leftwards
A1
A2
Macroeconomic equilibrium in the real sector
Investment demand depends on the interest rate
Savings depend on income Therefore, there is not a single
variable to clear the capital market The equilibrium in the capital
market depends on both income (Y) and interest rate (i)
Macroeconomic equilibrium in the real sector
AE
Y
AE1 the interest rate falls And investment spending increases
Y1
AE2
Y2
i
Y
i1
Y1
i2
Y2
IS
IS – curve of equilibrium in the real sector Supply of loanable funds = Demand for loanable fundsАЕ = Y on each point
Slope – depends on the elasticity of investment demand as regards the interest rate
E1
E2
Analysing the IS curve
i
Y
IS
The slope of the IS curve depends on theelasticity of Investment demand as regard interest rate
If the Ei is low, the curve is steep
All the points on IS present an equilibriumon the real sector (AE = Y) and show what should be the income (Y) be at every level ofinterest rate (i), so that AE = Y
If the economy is in point A, the Y is too low for the given i. At this low interest rate businesses will want to invest more. AE > Y. Inventories will fall and firms will increase orders to suppliers. Income will start rising until AE = Y at point A’
AA’
Factors, determining IS: Injections and Leakages
AE
Y
AE1
Government spending rises at the same level of interest rate and Y increases
Y1
AE2
Y2
i
Y
i1
Y1
i2
Y2
IS
IS – curve of equilibrium in the real sector АЕ = Y on each point
Point A shifts to the right to point A’, where will be the new equilibrium at i1The IS curve shifts rightwards
AA’
The increase in injections and the decrease inleakages shift the IS curve to the right. The decrease in injections and the increase inleakages shift the IS curve to the left
Equilibrium in the real sector and in the financial sector
i
Y
IS1 LM
Increase in exports
IS2
Y2
i1
Y1
IS shows what should the income be at every level of i.With the increase in exports, Y rises and IS shifts rightwards. This destroys the equilibrium in the monetary sector. LM shows what should the interest rate be atevery level of Y. At the higher income level Y2 i1 is lower than the equilibrium i. The public starts selling bonds,because they prefer more liquidity. MD rises. PV of bonds falls. PV = FV/f(i). The interest rate rises.
In the real sector investment falls, Y decreases andsavings fall too. The new equilibrium is achieved atpoint Е2
Е2
Е1
Equilibrium in the real sector and in the financial sector
i
Y
IS
LM1
E1
MS increases
LM2
LM shows what the interest rate should be at every level of income. The increase in MS reduces the iat the same income level Y1.
Y1
At a lower interest rate, however, I increase and AE > Y. Inventories fall, Y rises, and S increase, as well.
At the same time MD increases and the interest rate rises.
Е2
The new equilibrium is set at Е2