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Chapter 22Chapter 22The ISLM Model
1. Overview: IS-LM Model• Includes money and interest rates in the
Keynesian framework
• Examines an equilibrium where aggregate output equals aggregate demand
• Assumes fixed price level where nominal and real quantities are the same
• IS curve is the relationship between equilibrium aggregate output and the interest rate in the Goods Market
• LM curve is the combinations of interest rates and aggregate output for which MD = MS in the Money Market
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2. Goods Market: IS Curve
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The total quantity demanded of an economy's
output is the sum of four types of spending
Y ad C I G NX
Equilibrium occurs in the economy
when the total quantity of output supplied
equals the total quantity of output demanded
Y Y ad
Analysis assumes the price level is fixed
(1) Consumption Expenditures
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Consumption is an increasing function of
1) Disposable/After-tax Income(=Y-T), and
2) Wealth (=Value of Properties, Financial Assets, and Income Possibility(Human Wealth).
C = f( Y - T, W)
*Current Financial Crisis has a negative Wealth Effect: Value of Wealth down and Consumption down.
(2) Investment Spending = Fixed investment + Inventory investment
• Investment is a function of
(Ex-post real) Interest rates, and
Expectations.
I = f(i, Exp)
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(3) Government Expenditures• Expansionary Fiscal Policy
• Contractionary Fiscal Policy
These are up to the government’s discretion
G
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(4) Net ExportsNX = Exports – Imports
• Exports depend on ‘Their’ Foreign Demands, which depends on Y of foreign country‘Our’ Competitiveness• Imports depends on ‘Our Income’.• Foreign Exchange Rage affects NX as well
*The Current Financial Crisis originating from the U.S. has a serious impact on Canada through a decline in Exports.
NX = f(Y, Yforeign), FOREX rates)
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(5)Equilibrium in the Goods Market: The IS Curve
• Interest rates and investment spending– Negative relationship
• Investment and National Income
- Positive relationship
Thus, Interest rates(i) and National Income(Y)– Negative relationship
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(6)Deriving the IS Curve
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3. The LM Curve: Equilibrium in the Market for Money
• It is the combinations of (i,Y) that satisfy
the equilibrium condition in the money market:
Money supply = Money Demand
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(1) Money Supply
We have learned that the money supply curve is Vertical:Government’s supply decision does not depend on interest rate-
in other words, interest rate is a result of government decision, and not a factor that affects government decision.
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(2) Money Demand
Demand for money called liquidity preference
• Md/P depends on income (Y), interest rates (i),
and Random Shocks/Diturbances (u)
• Positively related to income– Raises the level of transactions– Increases wealth
• Negatively related to interest rates
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(3) Equilibrium in the Market for Money: The LM Curve (Cont’d)
• Connects points that satisfy the equilibrium condition that MD = MS
• For each level of aggregate output, the LM curve tells us what the interest rate must be for equilibrium to occur
• The economy tends to move toward points on the LM curve
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(4)Deriving the LM Curve
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*Different Slopes of LM curves:
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1
2
3
*Note that the slope of LM curve is the mirror image of the Md curve:
• When real money demand is perfectly elastic with respect to interest rate, the corresponding LM curve is almost horizontal.
• This is the case of ‘Liquidity Trap’.
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4. Combining IS-LM curves: Determination of Output and Interest Rate
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• In this chapter, we simply derive IS and LM curves.
• In the next chapter, we will talk about the shift of IS and LM curves.
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