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r0
When income
rises demand
for money
rises
L (r, Y1 )
L (r, Y0 )
M/ P L, M/P
r The asset-market
When money
supply
increases
r0
interest
rates fall for
the same
r1
level of
income.
L (r, Y0 )
M/ P M/P L, M/P
The LM curve
Assume a specific form of money-demand:
M/P = L1Y L2r.
r = (1/L2)M/P + (L1/L2)Y
This implies the following:
If Y increases, r rises (as discussed).
If M increases, the whole curve shifts right.
If P increases, the whole curve shifts left.
r The LM curve
LM
bond prices fall
and interest rates rise
to restore equilibrium.
r1
r0
When income
increases, demand for
money increases
Y0 Y1 Y
7.2 IS-LM model
The situation so far
For a given interest rate, r, the IS curve
determines spending and income.
For a given income, Y, the LM curve determines
the interest rate, r.
So, Y and r cannot be determined independently of
each other, but must be set simultaneously.
IS-LM model: what is the pair of r and Y so that
saving equals investment and the asset market
is in equilibrium at the same time?
Algebraically
IS: Y = m (a + G + I bT ) mhr.
LM: r = (1/L2)M/P + (L1/L2)Y
r0
IS (G, T, I)
Y0 Y
r A rise in G or I
LM (M/P)
r1
r0
IS (G, T, I)
IS (G, T, I)
Y0 Y1 Y
A rise in G or I
It is still true that this raises spending and
hence income.
Modification: but as it raises income, it also
raises interest rates.
So it discourages that part of investment that is
sensitive to interest rates, choking off some
of the increase in income (crowding out).
(Income does not increase by the full extent of
the multiplier.)
A rise in G
Now, unlike before, a rise in G is not an
unadulterated benefit.
Although it raises spending and income,
higher G discourages private investment,
since it raises interest rates.
Then a choice must be made between
government spending and private
investment spending.
Increasing money supply
LM (M/P)
r0
A higher money supply
r1 lowers interest rates and
raises income and output.
IS (G, T, I)
Y0 Y1 Y
Fiscal policy
Bangko Sentral
Government
Treasury
Sell bonds Pay with new money
to finance deficit
r1
r0
IS (G, T, I)
IS (G, T, I)
Y0 Y1 Y
Ar rise in G with higher M
LM (M/P)
Monetary LM (M/P)
policy keeps
interest
rates
constant
r10
IS (G, T, I)
IS (G, T, I)
Y0 Y1 Y
income increases
by the full multiplier
Interaction between fiscal
and monetary policy
If BSP keeps money supply constant as
NG expands fiscally, interest rates rise and
private investment in crowded out.
Big difference: if the BSP fully
accommodates the fiscal expansion by
expanding money, interest rates do not
rise. There is no crowding out, and the
effect of fiscal policy is much greater.
THIS CONCLUDES THE
MATERIAL FOR THE
2. EXAM
7.3 Price and aggregate demand
IS-LM and aggregate demand
r1
r0
IS
Y
Y0
P
P
AD
Y1 Y0
Y
A higher P reduces spending
r1
r0
IS
Y
Y0
AD(M)
AD(M)
Y1 Y0
Y
Price and consumption
Previously:
C = a + b (Y T )
says consumption depends on income.
But it is also possible consumption depends
on real wealth, or real money balances.
C = a + b (Y T ) + e (Z /P)
where Z is nominal wealth, including money.
Price level and consumption
r1
r0 IS(G)
IS(G)
Y
Y0
AD(G)
AD(G)
Y0 Y1
Y
A higher G or lower T shifts AD right
SRAS
as prices change
AD
(slowly) full employment
is regained
AD
Y
Short and long run
r
LRAS
Demand shock quickly raises
output above full employment;
prices remain constant
AD
AD
Y
A supply shock, e.g., higher
oil prices
r
LRAS
Prices rise rapidly, reducing
aggregate demand and
output
SRAS
SRAS
Y
Essence of the policy debate over
government intervention
Conservative line: no need for government
intervention; automatic mechanism will ensure
full employment is regained. (In addition a
dislike for enlarging scope of government,
displacing private investment, etc.)
Keynesian argument: How long (if at all) will it
take prices to change so that full employment is
regained? In the long run, we are all dead.
(Argument for government intervention through
fiscal and monetary policy)
End