KuliahImoneter Chap 2-5

(2,5 HOURS = 115 SLIDES: CH.
2-5)
Moneteryeconomics: A REVIEW OF
THE IS-LM
Prepared By
Prof. Dr. H.M.Yunus Zain, M.A.
and
Dr. Hj. Rahmatia Yunus,M.A.
(DOSEN TETAP FE-PPS UNHAS
2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 1
Economics: State of the arts

The state & results of Macroeconomics
Two classic welfare theorem

-market hold, CE is Pareto
efficient
-market failure, redistribution
initial endowment, the CE is also
Pareto optimal
Microeconomics
results: partial &
GE:
-Consumers efficiency
MRSij= relatif price ij
-Porduction efficiency
MRTSij= relative factor
price ij
Source of Market failure & government intervention -Exchange efficiency
(market efficiency)
Field development:
-Public Economics (Choice)
-New Political Economy
-Regional economics
-HRE: Labor Ec.; Health Ec
-others subjects
Macroeconomics, 3/e
-Development Economics
-International economics
-monetary economics
-others subjects
Four Functional
Management?
Olivier Blanchard
MYZ/RY 2
State of the arts and results of

Economic Theory (A)
State of the arts and results of

Social-political Theory (B)
New political Economy Politik ekonomi?

Ekonomi politik
Why (event) What/how (before and
after the fact):
-process
-institutional setting
science
Mathematics & Philosophy: an ARTS
New Political Economy: Toward a

Multidiscipline?
Facts:
empirical
questions
What/how (before the

fact):
-behavioral foundation
-Rational (self-interest?)
New (?) Paradigm

Macroeconomics, 3/e
A or B; or both
Olivier Blanchard
MYZ/RY 3
Is the development in the fields of Economics (even as an

economist) just like Ms. MADONNA? A fashion matter!
Mainstream economics:
-more deductive
-abstraction: more use mathematical
exposition especially in theoretical work
-developed on both applied and theoretical
work to explain the stylized fact
How about the type of Economist?
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 4
THE STRUCTURE OF THIS LECTURE

CH. 2: MACROECONOMIC INDICATORS
CH. 3: The Goods Market
CH. 4: Financial Markets
CH. 5: Goods and Financial Markets
The IS-LM Model
NEXT LECTURE DEAL ABOUT MEDIUM RUN
ANALYSIS (AS-AD, CH 6-9) AND LONG RUN
(CH 10-13) from Blanchard (2003)
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 5
Goal of this lecture (ch.2)

Defining these indicators more precisely,
Chapter 2 [Blanchard]
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 6
C H AP TE R
2. Macroeconomic
indicators
Prepared by:
M. Yunus Zain & Rahmatia Yunus
(FE-UNHAS)
Macroeconomics, 3/e Olivier Blanchard
MYZ/RY 7
2-1
Aggregate Output
Measures of aggregate economic
activity?
National income and product
accounts, or GNP
Measure of aggregate output in the

national income accounts is gross
domestic product, or GDP.
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 8
GDP: Production and Income

There are three ways of defining GDP:
1.
GDP is the value of the final goods and services produced

in the economy during a given period.
Difference between a final good and an intermediary good
Example:
-
Simple economy, produce only cars:
10 cars, worth $21 each
GDP = $ 210
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 9

2. GDP is the sum of value added in the economy
during a given period.
Value added =
Value of firms production - Value of intermediary
goods
Another firm produces steel.

For each car, you need to buy for $ 10 steel ($100 in total)
Value added:
Firm 1 (steel): $ 100

+ Firm 2 (cars): $ 210 - $ 100 = $ 110
Sum = $ 210
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 10

3. GDP is the sum of the incomes in the economy
during a given period.
PRODUCTION SIDE
INCOME SIDE
Firm 1 (steel)
pays workers: $ 80
$ 100
20
makes a profit: $
Firm 2 (car)
buys steel: $ 100
$ 210
pays workers: $ 70
makes a profit: $
$ 210
40
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 11
Table 2-1 The Composition of GDP by Type of Income,

1960 and 2000
(in percent)
1960
2000
Labor income
66
65
Capital income
26
28
Indirect taxes
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 12
Nominal and real GDP

Year
Number
Price
Value in $
1990 5 cars
2000 10 cars
$ 100
$ 200
$ 500
$ 2 000
Year
Price
Value in $
1990 1 computer
$ 100
$ 100
2000 5 computers
$ 120
$ 600
Number
Year
Nominal
GDP in $ of 90
1990 $ 500 + $ 100

2000 $ 2 000 + $ 600
$ 600
$ 2 600
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 13
Nominal and Real GDP

Can you think of any way of measuring the
GDP in real terms?
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 14

Year
Number
Price
GDP in $
1990 5 cars
2000 10 cars
$ 100
$ 200
$ 500
$ 2 000
Year
Price
GDP in $
1990 1 computer
$ 100
$ 100
2000 5 computers
$ 120
$ 600
Number
Year
Real
GDP in $ of 90
1990 5 X 100 + 1 X 100

2000 10 X 100 + 5 X 100
$ 600
$ 1500
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 15

Nominal and Real
GDP U.S. GDP,
1960-2000
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 16

GDP growth equals (please use real GDP):
(Yt Yt 1 )
Yt 1
expansions
recessions
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 17
2-2
The Other Major

Macroeconomic Variables
Unemployment
Inflation
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 18
The Unemployment and participation rates

How many people contribute to the domestic production ?
65+
Unemployed
Not
15-64
participating
Employed
0-15
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 19
The Unemployment Rate
Unemployed
UR =
Unemployed
Employed
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 20
The Unemployment Rate

labor force = employed + unemployed
L
=
N
+
U
Unemployment rate:
2000
U
u
L
5 .7
4 .0 %
1 3 5 .2 5 .7
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 21
The participation rate

Unemployed
Employed
PR=
Unemployed
Not
participating
Employed
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 22
The Inflation Rate

Inflation is a sustained rise in the general
level of pricesthe price level.
The inflation rate is the rate at which the
price level increases.
Deflation is a sustained decline in the
price level, or a negative inflation rate.
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 23
The GDP Deflator

n o m in a l G D P t $ Y t
Pt
real G D Pt
Yt
The GDP deflator is what is called an index

numberset equal to 100 in the base year.
The rate of change in the GDP deflator equals
the rate of inflation:
( P t P t1 )
P t1
Nominal GDP is equal to the GDP deflator
times real GDP: $ Y t P t Y t
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 24
The Consumer Price Index

GDP deflator versus consumer price index
(CPI)
How do they behave?
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 25
The Consumer Price Index

Inflation Rate,
Using the CPI and
the GDP Deflator,
1960-2000
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 26
How do the three variables relate to each

other?
Growth rate
Unemployment rate
Inflation rate
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 27
Change in the Unemployment Rate Versus

GDP Growth, United States, 1960-2000
Okuns law
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 28
Change in the U.S. Inflation Rate Versus

the U.S. Unemployment Rate, 1970-2000
Phillips Curve
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 29
What drives the macroeconomic

indicators?
Why do we have booms and recessions?
Why do some countries grow more than
others?
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 30
2-3
A Road Map
Output is determined by:

demand in the short run, say, a few years,
the level of technology, the capital stock, and the
labor force in the medium run, say, a decade or

so,
factors such as education, research, saving, and
the quality of government in the long run, say, a
half century or more.
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 31
The Organization of the Book

[Blanchard, 2003)
The Focus of our Lecture

is here only!
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 32
Exercises
[B] Chapter 1, problems 2, 3, 5
[B] Chapter 2, problems 2, 3, 4, 5, 6, 8
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 33
C H AP TE R
3. The Goods Market
Prepared by:
(FE-UNHAS)
MYZ/RY 34
Summary of last time ([B] ch. 2)

Definitions of:
GDP
Income
Sum of Value added
Production
Unemployment rate
Inflation rate
Consumer price index
GDP deflator
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 35
Questions? Please raise it now!
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 36
Goals of this chapter 3 (lecture)

Describe the composition of the GDP
See how the equilibrium output is determined
in the short run
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 37
3-1
The Composition of GDP
Table 3-1
The Composition of U.S. GDP, 2001

Billions of
dollars
GDP (Y)
Percent of
GDP
10,208
100
1.
Consumption (C)
7,064
69
2.
Investment (I)
1,692
17
1,246
12
446
Nonresidential
Residential
3.
Government spending (G)
1,839
18
4.
Net exports = X - M
Exports (X)
329
1,097
3
11
Imports (IM)
1,468
14
58
5.
Inventory investment
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 38
3-2
The Demand for Goods
The total demand for goods (aggregate

demand, AD) is written as:
Z C I G X IM
The symbol means that this equation is an
identity, or definition.
Under the assumption that the economy is
closed, X = IM = 0, then:
Z C I G
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 39
Consumption (C)
C C (Y D )
( )
The function C(YD) is the consumption

function (behavioral equation).
Disposable income:
YD Y T
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 40
Consumption (C)
A more specific form of the consumption
function is this linear relation:
C c 0 c 1Y D
This function has two parameters, c0 and c1:
c1 (marginal) propensity to consume
c0 is the intercept of the consumption
function.
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 41
Consumption (C)
Consumption and
Disposable Income
C C (Y D )
YD Y T
C c 0 c1 (Y T )
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 42
Investment (I): assumed autonomous or

exogenous
I I
Note: Distinction Exogenous - Endogenous
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 43
Government Spending (G)

Government spending, G, together with taxes,
T, describes fiscal policythe choice of taxes
and spending by the government.
We shall assume that G and T are also
exogenous.
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 44
3-3
The Determination of
Equilibrium Output
Equilibrium in the goods market requires

that production, Y, be equal to the demand for
goods, Z:
Y Z
Then:
Y c 0 c1 (Y T ) I G
The equilibrium condition is that,

production = income =Y = demand (Z).
Demand (Z) depends on Y.
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 45
Demand, production and income
Production
Demand
Macroeconomics, 3/e
Income
Olivier Blanchard
MYZ/RY 46
Using Algebra
The equilibrium equation can be manipulated to derive
some important terms:
Autonomous spending and the multiplier:
Y c0 c1 (Y T ) I G
Y c0 c1Y c1T I G
(1 c 1 )Y c 0 c 1 I G c 1T
Y
1
1 c1
[c 0 I G c1T ]
multiplier
autonomous spending
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 47
Using a Graph
Equilibrium in the Goods
Market
Z ( c 0 I G c 1T ) c 1Y
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 48
Using a Graph
The Effects of an
Increase in Autonomous
Spending on Output
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 49
Using a Graph
The multiplier is the sum of successive
increases in production resulting from an
increase in demand.
When demand is, say, $1 billion higher, the
total increase in production after n rounds of
increase in demand equals $1 billion times:
1 c 1 c 1 2 . . . c 1 n
This sum is called a geometric series.
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 50
How Long Does It Take

for Output to Adjust?
How do we go from one equilibrium to the
other?
Describing formally the adjustment of output
over time is what economists call the
dynamics of adjustment.
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 51
Consumer Confidence and the 19901991 Recession

Forecast errors
Consumer confidence index
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 52
Consumer Confidence and the 19901991 Recession

Table 1 GDP, Consumption, and Forecast Errors, 1990-1991
(1)
Change in
Real GDP
(2)
Forecast Error
for GDP
1990:2
19
17
23
105
1990:3
29
57
90
1990:4
63
88
37
61
1991:1
31
27
27
47
30
8
65
Quarter
1991:2
(3)
(4)
Forecast Index of Consumer
Error for c0
Confidence
Macroeconomics, 3/e
Olivier Blanchard
77
MYZ/RY 53
3-4 Investment Equals Saving: An Alternative

Way of Thinking about Goods-Market Equilibrium
Saving is the sum of private plus public saving.

Private saving (S), is saving by consumers.
Private saving
Public saving = T - G.
S YD C
If T > G: budget surplus
If T < G: budget deficit
S Y T C
Y C I G
Y T C I G T
S I G T
I S (T G )
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 54
Investment Equals Saving: An Alternative

I S (T G )
IS relation
What firms want to invest must be equal to
what people and the government want to save.
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 55
Investment Equals Saving: An Alternative

Consumption and saving decisions are one and the
same.
The term (1c) is

S Y T C
called the
S Y T c0 c1 (Y T )
S c 0 (1 c 1 )(Y T )
propensity to save.
In equilibrium:
I c 0 (1 c 1 )(Y T ) ( T G )
Rearranging terms, we get the same result as
before:
1
Y
[c 0 I G c1T ]
1 c1
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 56
The Paradox of Saving

When consumers save more, spending
decreases and equilibrium output is lower.
Attempts by people to save more lead both to
a decline in output and to unchanged saving.
This surprising pair of results is known as the
paradox of saving (or the paradox of thrift).
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 57
3-5
Is the Government Omnipotent?

A Warning
Changing government spending or taxes may

be far from easy.
The responses of consumption, investment,
imports, etc, are hard to assess with much
certainty.
Anticipations are a likely matter.
Achieving a given level of output may come
with unpleasant side effects.
Budget deficits and public debt may have
adverse implications in the long run.
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 58
Exercises
Chapter 3, problems 4,5,6
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 59
C H AP TE R
4. Financial Markets
Prepared by:
(FE-UNHAS)
MYZ/RY 60
4-1
The Demand for Money
Money,
pays no interest
Used for transactions
Types:
currency
checkable deposits.
Bonds
pay a positive interest rate , i,
cannot be used for transactions.
The proportions of money and bonds you wish to hold

depend on your level of transactions and the interest rate on
bonds.
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 61
Semantic trap
Difference between a flow and a stock:
Wealtht
Wealtht+1
t+1
Macroeconomics, 3/e
Olivier Blanchard
time
MYZ/RY 62
Semantic trap
Income
Savings
Wealtht
Wealtht+1
t+1
Macroeconomics, 3/e
Olivier Blanchard
time
MYZ/RY 63
Semantic trap
Savings
Wealtht
Wealtht+1
t+1
Macroeconomics, 3/e
Olivier Blanchard
time
MYZ/RY 64
Difference between flow and stock

Stock: Defined at a precise moment in time
Example: Wealth, unemployment
Flow: Defined over a period of time

Examples: Savings, income
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 65
Semantic Traps:
Money, Income, and Wealth
Money Wealth
Money Income
Wealth Saving
Investment Financial investment
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 66
Deriving the Demand for Money
$ Y L (i)
The demand for money:

increases in proportion to transactions (nominal
income ($Y)), and

depends negatively on the interest rate (L(i)).
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 67
Deriving the Demand for Money

The Demand for Money
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 68
4-2
the Interest Rate, I
In this section, we assume that only the central

bank supplies money, in an amount equal to
M, so M = Ms.
People hold only currency as money.
Equilibrium in financial markets requires that
money supply be equal to money demand:
M $ Y L (i)
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 69
Money Demand, Money Supply; and

the Equilibrium Interest Rate
The Determination of the
Interest Rate
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 70
Money Demand, Money Supply; and

the Equilibrium Interest Rate
The Effects of an
Increase in
Nominal Income on the
Interest Rate
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 71
The Demand for Money and the

Interest Rate: The Evidence
The interest rate and the ratio of money to nominal

income typically move in opposite directions.
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 72
Monetary Policy and

Open-Market Operations
The Effects of an
Increase in the Money
Supply on the Interest
Rate
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 73
Monetary Policy and

Open-market operations
Bonds:
Promise of a certain value at a certain date:
For example: $100, 01-03-2007
Price today: Pt
Interest rate:
$100 Pt
i
Pt
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 74
Monetary Policy and

The Balance Sheet of the
Central Bank and the Effects of
an Expansionary Open Market
Operation
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 75
Monetary Policy and

Expansionary open
market operation
Ms
Buy bonds
Contractionary open
market operation
Ms
Sell bonds
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 76
Monetary Policy and

Bonds issued by the government, promising a
payment in a year or less, are called Treasury
bills, or T-bills
When the central bank buys bonds, the
demand for bonds goes up, increasing the
price of bonds. Equivalently, the interest rate
on bonds goes down.
$100 $ PB
i
$ PB
$ PB
Macroeconomics, 3/e
$100
1 i
Olivier Blanchard
MYZ/RY 77
4-3
the Interest Rate, II
Financial intermediaries are institutions that

receive funds from people and firms, and use
these funds to buy bonds or stocks, or to
make loans to other people and firms.
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 78
The Balance Sheet of Banks and the Balance

Sheet of the Central Bank Revisited
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 79
What Banks Do
Banks keep as reserves some of the funds
they have received, for three reasons:
To honor depositors withdrawals
To pay what the bank owes to other banks
To maintain the legal reserve requirement, or portion
of checkable deposits that must be kept as reserves:

The reserve ratio is the ratio of bank reserves to
checkable deposits (currently about 10% in the United

States).
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 80
What Banks Do
Loans represent roughly 70% of banks
nonreserve assets. Bonds account for the
other 30%.
The assets of a central bank are the bonds it
holds. The liabilities are the money it has
issued, central bank money, which is held as
currency by the public, and as reserves by
banks.
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 81
Bank Runs
bank run.
federal deposit insurance.
alternative solution: narrow banking,
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 82
Determinants of the Demand and

the Supply of Central Bank Money
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 83
The Demand for Money, Reserves,

and Central Bank Money
Demand for currency: C U
cM
Demand for checkable deposits: D
(1 c ) M
Relation between deposits (D) and reserves (R): R = qD

Demand for reserves by banks: R d = q( 1- c )M d
Demand for central bank money: H
CU
Then: H d = cM d + q( 1- c )M d = [ c + q( 1- c )]M d
Since M
$ Y L ( i ) Then: H d = [c + q(1- c)]$YL(i )
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 84
The Determination of the Interest Rate
In equilibrium, the supply of central bank

money (H) is equal to the demand for central
bank money (Hd):
H H
Or restated as:
H = [ c + q( 1 - c )]$YL( i )
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 85
The Determination of the Interest Rate

Equilibrium in the
Market for Central Bank
Money, and the
Determination of the
Interest Rate
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 86
4-4
Two Alternative Ways to

Think about the Equilibrium
The equilibrium condition that the supply and

the demand for bank reserves be equal is
given by:
d
d
H CU
The federal funds market is a market for

bank reserves. In equilibrium, demand ( Rd)
must equal supply (H-CUd). The interest rate
determined in the market is called the federal
funds rate.
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 87
The Supply of Money, the Demand for

Money and the Money Multiplier
The overall supply of money is equal to central
bank money times the money multiplier:
H = [ c + q( 1 - c )]$YL( i )
Then:
1
H = $YL( i )
[ c + q( 1 - c )]
Supply of money = Demand for money
High-powered money is the term used to

reflect the fact that the overall supply of money
depends in the end on the amount of central
bank money (H), or monetary base.
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 88
Exercises
Chapter 4, problems 4, 5, 6, 7
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 89
C H AP TE R
5. Goods and
Financial Markets:
The IS-LM Model
Prepared by:
(FE-UNHAS)
MYZ/RY 90
Diagram for Goods and Financial (Money)

Markets Relation in IS-LM Framework
interest rate, i
I = f (Y, i)
Monetary policy
Money market equilibrium
Goods market equilibrium
M-supply = M-demand
Y=Z
LM curve (I,Y)
IS curve (i,Y)
Fiscal Policy
Income, Y
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 91
Goods and Financial markets

1) Equilibrium on the Goods market: Y
2) Equilibrium on the financial market: I
3) Link these two markets
Y = C + I(Y,i) + G IS
$Y L(i) = M
LM
Graph with Y on the horizontal axis and i on the vertical

axis
i IS
LM
Y (see 5.3.)
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 92
5-1
The Goods Market

and the IS Relation
Equilibrium in the goods market exists when

production, Y, is equal to the demand for
goods, Z.
In the simple model developed in chapter 3,
the interest rate did not affect the demand for
goods. The equilibrium condition was given
by:
Y C (Y T ) I G
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 93
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 (-)
I I (Y ,i)
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 94
The Determination of Output

I I (Y ,i)
Taking into account the investment relation

above, the equilibrium condition in the goods
market becomes:
Y C (Y T ) I (Y ,i) G
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 95
The Determination of Output

Equilibrium in the Goods
Market
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 96
Deriving the IS Curve

The Effects of an
Increase in
the Interest Rate on
Output
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 97
Deriving the IS Curve

The Derivation of the IS
Curve
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 98
Shifts of the IS Curve

Shifts of the IS
Curve
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 99
5-2
Financial Markets
and the LM Relation
The interest rate is determined by the equality

of the supply of and the demand for money:
M $ Y L (i)
M = nominal money stock
$YL(i) = demand for money
$Y = nominal income
i = nominal interest rate
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 100
Real Money, Real Income,

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:
M
Y L (i)
P
From chapter 2, recall that Nominal GDP = Real GDP

multiplied by the GDP deflator:
$Y YP
Equivalently:
$Y
Y
P
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 101
Deriving the LM Curve

The Effects of an
Increase in Income on
the Interest Rate
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 102
Deriving the LM Curve

The Derivation of the
LM Curve
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 103
Shifts of the LM Curve

Shifts of the LM
Curve
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 104
5-3
Putting the IS and the

LM Relations Together
The IS-LM Model
IS r e la tio n : Y C (Y T ) I (Y ,i ) G
L M r e la tio n :
Macroeconomics, 3/e
M
Y L (i)
P
Olivier Blanchard
MYZ/RY 105
Fiscal Policy, Activity,

Fiscal contraction or Fiscal consolidation
Fiscal expansion.
affects the IS curve, not the LM curve.
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 106
Fiscal Policy, Activity,

The Effects of an
Increase in Taxes
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 107
Monetary Policy, Activity,

Monetary contraction, or monetary
tightening
Monetary expansion.
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 108
Monetary Policy, Activity,

The Effects of a
Monetary Expansion
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 109
Monetary and Fiscal policies

Monetary Policy: M, shifts the LM curve
Fiscal Policy: T,G, shifts the IS curve
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 110
5-4
Using a Policy Mix
The combination of monetary and fiscal polices is

known as the monetary-fiscal policy mix, or simply,
the policy mix.
Table 5-1
The Effects of Fiscal and Monetary Policy.

Shift of IS
Shift of
LM
Movement of
Output
Movement in
Interest Rate
Increase in taxes
left
none
down
down
Decrease in taxes
right
none
up
up
Increase in spending
right
none
up
up
Decrease in spending
left
none
down
down
Increase in money
none
down
up
down
Decrease in money
none
up
down
up
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 111
The Clinton-Greenspan Policy Mix
Table 5-2
Selected Macro Variables for the United States,

1991-1998
1991
1992
1993
1994
1995
1996
1997
1998
0.8
Budget surplus (% of
GDP)
(minus sign = deficit)
3.3 4.5 3.8 2.7 2.4 1.4 0.3
GDP growth (%)
0.9
2.7
2.3
3.4
2.0
2.7
3.9
3.7
Interest rate (%)
7.3
5.5
3.7
3.3
5.0
5.6
5.2
4.8
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 112
The Clinton-Greenspan Policy Mix

Deficit Reduction and
Monetary Expansion
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 113
German Unification and the German

Monetary-Fiscal Tug of War
Table 5-2
1991
Selected Macro Variables for West Germany, 19881991
1992
1993
1994
GDP growth (%)
3.7
3.8
4.5
3.1
Investment growth (%)
5.9
8.5
10.5
6.7
2.1
0.2
1.8
2.9
4.3
7.1
8.5
9.2
Budget surplus (% of GDP)

(minus sign = deficit)
Interest rate (%)
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 114
German Unification and the German

Monetary-Fiscal Tug of War
The Monetary-Fiscal
Policy Mix of PostUnification Germany
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 115
Dynamics
1. Starting point: Suppose the equilibrium is at
the natural rate of output => Pe = P*
2. Determine whether the shock affects the
natural rate of unemployment
Changes in , z (AS curve)

Monetary policy, budgetary policies: no (AD curve)
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 116
Dynamics (II)
3. Determine the shifts in the AS-AD diagram
4. Adjustments
1. Determine the expected price level Pe
2. Determine the equilibrium price level P
3. If Pe > P* Pe AS shifts downwards P*
4. If Pe < P* Pe AS shifts upwards P*
5. In the IS-LM model

1. Determine which curve shifts
2. Remember that LM will always shift as well since
P changes
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 117
Exercises
Chapter 5, problems 2, 3, 5, 6
See also data of Indonesia cases in last
lecture (i.e., lecture III)
Macroeconomics, 3/e
Olivier Blanchard
MYZ/RY 118

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(2,5 HOURS = 115 SLIDES: CH.

Economics: State of the arts

Two classic welfare theorem

2003 Prentice Hall Business Publishing

State of the arts and results of

State of the arts and results of

New political Economy Politik ekonomi?

Mathematics & Philosophy: an ARTS

New Political Economy: Toward a

2003 Prentice Hall Business Publishing

What/how (before the

New (?) Paradigm

Is the development in the fields of Economics (even as an

2003 Prentice Hall Business Publishing

THE STRUCTURE OF THIS LECTURE

Goal of this lecture (ch.2)

2003 Prentice Hall Business Publishing

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e Olivier Blanchard

Measure of aggregate output in the

2003 Prentice Hall Business Publishing

GDP: Production and Income

GDP is the value of the final goods and services produced

Simple economy, produce only cars:

10 cars, worth $21 each

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GDP: Production and Income

Another firm produces steel.

Firm 1 (steel): $ 100

GDP: Production and Income

buys steel: $ 100

GDP: Production and Income

Table 2-1 The Composition of GDP by Type of Income,

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Nominal and real GDP

1990 $ 500 + $ 100

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Nominal and Real GDP

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Nominal and Real GDP

1990 5 X 100 + 1 X 100

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Nominal and Real GDP

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Nominal and Real GDP

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The Other Major

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The Unemployment and participation rates

The Unemployment Rate

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The Unemployment Rate

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The participation rate

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The Inflation Rate

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The GDP Deflator

The GDP deflator is what is called an index

The Consumer Price Index

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The Consumer Price Index

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How do the three variables relate to each