1,Lecture 4 the IS-LM model,The Short Run,2,Section 4-1: The Goods Market and the IS Relation Section 4-2: Financial Markets and the LM Relation Section 4-3: Putting the IS and the LM Relations Together Section 4-4: Using a Policy Mix,3,Section 4-1 The Goods Market and the IS Relation,Equilibrium in the goods market exists when production, Y, is equal to the demand for goods, Z. This condition is called the IS relation.The equilibrium condition was given by:,or,In the simple model, the interest rate did not affect the demand for goods.,4,Investment, Sales, and the Interest Rate,In this chapter, we capture the effects of two factors affecting investment: The level of sales (+) The interest rate (-),5,Determining Output,Taking into account the investment relation above, the equilibrium condition in the goods market becomes:,6,The Determination of Output,The demand for goods is an increasing function of output. Equilibrium requires that the demand for goods be equal to output.,Equilibrium in the Goods Market,7,The Determination of Output,Note two characteristics of ZZ: Because its not assumed that the consumption and investment relations are linear, ZZ is, in general, a curve rather than a line. ZZ is drawn flatter than a 45-degree line because its assumed that an increase in output leads to a less than one-for-one increase in demand.,8,Deriving the IS Curve,An increase in the interest rate decreases the demand for goods at any level of output.,The Effects of an Increase in the Interest Rate on Output,9,Deriving the IS Curve,Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output. The IS curve is downward sloping.,The Derivation of the IS Curve,10,Shifts of the IS Curve,An increase in taxes shifts the IS curve to the left.,Shifts of the IS Curve,11,Shifts of the IS Curve,Lets summarize: Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output.This relation is represented by the downward-sloping IS curve. Changes in factors that change the demand for goods, given the interest rate ,will shift the IS curve.,12,Section 4-2: Financial Markets and the LM Relation,The interest rate is determined by the equality of the supply of and the demand for money:,M = nominal money stock $YL(i) = demand for money $Y = nominal income i = nominal interest rate,13,Real Money, Real Income, and the Interest Rate,Recall that GDP deflator Nominal GDP = Real GDP multiplied by the GDP deflator:,The LM relation: In equilibrium, the real money supply is equal to the real money demand, which depends on real income, Y, and the interest rate, i:,14,Deriving the LM Curve,An increase in income leads, at a given interest rate, to an increase in the demand for money. Given the money supply, this leads to an increase in the equilibrium interest rate.,The Effects of an Increase in Income on the Interest Rate,15,Deriving the LM Curve,Equilibrium in financial markets implies that an increase in income leads to an increase in the interest rate. The LM curve is upward-sloping.,The Derivation of the LM Curve,16,Shifts of the LM Curve,The Effects of a change in money supply,17,Shifts of the LM Curve,An increase in money supply leads the LM curve to shift down.,Shifts of the LM Curve,18,Shifts of the LM Curve,Lets summarize: Equilibrium in financial markets implies that, for a given real money supply, an increase in the level of income, which increases the demand for money, leads to an increase in the interest rate.This relation is represented by the upward-sloping LM curve. An increase in the money supply shifts the LM curve down; a decrease in the money supply shifts the LM curve up.,19,Section 4-3: Putting the IS and the LM Relations Together,Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output. Equilibrium in financial markets implies that an increase in output leads to an increase in the interest rate. When the IS curve intersects the LM curve, both goods and financial markets are in equilibrium.,The IS-LM Model,20,John Hicks(8 April 1904 20 May 1989) was a British economist and one of the most important and influential economists of the twentieth century. The most familiar of his many contributions in the field of economics were his statement of consumer demand theory in microeconomics, and the IS/LM model (1937), which summarised a Keynesian view of macroeconomics.,Alvin Harvey Hansen (August 23, 1887 June 6, 1975), often referred to as “the American Keynes,“ was a professor of economics at Harvard, a widely read author on current economic issues, and an influential advisor to the government who helped create the Council of Economic Advisors and the Social security system. from wikipedia,21,Fiscal Policy, Activity, and the Interest Rate,Fiscal contraction, or fiscal consolidation, refers to fiscal policy that reduces the budget deficit. An increase in the deficit is called a fi