Post on 05-Apr-2018
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Economic Environment of Business
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Partha Chatterjee, FMS, University of Delhi
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So far
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Goods market Market for money and bonds
Next:
We will combine those two
Study IS-LM model
Talk about Fiscal and Monetary Policy
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The Goods Market
and the ISRelation
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Equilibrium in the goods market exists whenproduction, Y, is equal to the demand for goods, Z.This condition is called the IS relation.
In the simple model developed earlier, the interestrate did not affect the demand for goods. Theequilibrium condition was given by:
Y C Y T I G ( )
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Investment, Sales,
and the Interest Rate
Here, we capture the effects of two factorsaffecting investment:
The level of sales (+)
The interest rate (-)
( , )
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I I Y i ( , )
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Determining Output
Taking into account the investment relation
above, the equilibrium condition in the goodsmarket becomes:
( , )
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I I Y i ( , )
Y C Y T I Y i G ( ) ( , )
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Determining Output
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For a given value of the interest rate i, demandis an increasing function of output, for tworeasons:
An increase in output leads to an increase inincome and also to an increase in disposableincome.
An increase in output also leads to an
increase in investment.
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The Determination of Output
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The demand for goods is
an increasing function ofoutput. Equilibrium
requires that the demand
for goods be equal to
output.
Equilibrium in theGoods Market
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The Determination of Output
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Note two characteristics of ZZ:
Because its not assumed
that the consumption and
investment relations arelinear, ZZ is, in general, a
curve rather than a line.
ZZ is drawn flatter than a
45-degree line because its
assumed that an increasein output leads to a less
than one-for-one increase
in demand.
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Deriving the ISCurve
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An increase in theinterest rate decreases
the demand for goods at
any level of output.
The Effects of anIncrease inthe Interest Rate onOutput
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Deriving the ISCurve
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Equilibrium in the goodsmarket implies that anincrease in the interest
rate leads to a decreasein output. The IScurve isdownward sloping.
The Derivation of the ISCurve
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Deriving the ISCurve
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Using the last slide, we can find the relation betweenequilibrium output and the interest rate.
Panel (a) reproduces the figure in the last slide. Theinterest rate iimplies a level of output equal to Y.
Panel (b) plots equilibrium output Yon the horizontal
axis against the interest rate on the vertical axis.
This relation between the interest rate and output isrepresented by the downward sloping curve, or IScurve.
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Example: Shifts of the ISCurvedue to Tax
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An increase intaxes shifts the IS
curve to the left.
Shifts of the IS
Curve
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Shifts of the ISCurve
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Lets summarize:
Equilibrium in the goods market implies that an
increase in the interest rate leads to a decrease inoutput.
Changes in factors that decrease the demand forgoods, given the interest rate shift the IScurve to the
left.
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Financial Markets
and the LMRelation
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The interest rate is determined by the equality ofthe supply of and the demand for money:
M YL i $ ( )
M= nominal money stock$YL(i) = demand for money$Y= nominal incomei= nominal interest rate
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Real Money, Real Income,
and the Interest Rate
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The LMrelation: In equilibrium, the real moneysupply is equal to the real money demand, whichdepends on real income, Y, and the interest rate, i:
M
PYL i ( )
$Y YP
Recall that Nominal GDP = Real GDP multipliedby the GDP deflator:
$Y
PY
Equivalently:
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Deriving the LMCurve
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An increase inincome leads, at agiven interest rate, toan increase in thedemand for money.Given the moneysupply, this leads toan increase in theequilibrium interestrate.
The Effects of anIncrease in Income onthe Interest Rate
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Deriving the LMCurve
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Equilibrium infinancial markets
implies that anincrease in incomeleads to an increase inthe interest rate. TheLMcurve is upward-sloping.
The Derivation of theLM Curve
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Deriving the LMCurve
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From the figure we learn:
Panel (b) plots the equilibrium interest rate ion thevertical axis against income on the horizontal axis
This relation between output and the interest rate isrepresented by the upward-sloping curve in Panel (b).This curve is called the LMcurve.
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Ex: Shifts of the LMCurvedue to
changes in real money
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An increase inmoney leads
the LMcurve toshift down.
Shifts of the LM
Curve
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Shifts of the LMCurve
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Lets summarize:
Equilibrium in financial markets implies that, for a
given real money supply, an increase in the level ofincome, which increases the demand for money, leadsto an increase in the interest rate.
An increase in the money supply shifts the LMcurve
down; a decrease in the money supply shifts the LMcurve up.
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Remember
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BothIS
andLM
curves represent relations betweenY& i. IS is for the goods market & LM is for the
financial market.
IScurve: from the goods market equilibrium
condition express Yas a function of i(or vice-versa) LMcurve: from the financial market equilibrium
condition express Yas a function of i(or vice-versa)
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Putting the ISand the
LMRelations Together
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Equilibrium in the goodsmarket implies that an increase
in the interest rate leads to adecrease in output. Equilibriumin financial markets implies thatan increase in output leads toan increase in the interest rate.When the IScurve intersects
the LMcurve, both goods andfinancial markets are inequilibrium.
IS relation: Y C Y T I Y i G( ) ( , )
LM relation:M
P YL i( )
The IS-LM Model
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Fiscal Policy, Activity,
and the Interest Rate
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Fiscal contraction, or fiscalconsolidation, refers to fiscal policy thatreduces the budget deficit.
An increase in the deficit is called afiscal expansion.
Taxes affect the IScurve, not the LMcurve.
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Fiscal Policy, Activity,
and the Interest Rate
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The Effects of anIncrease in Taxes
An increase in
taxes shifts the IS
curve to the left, and
leads to a decrease
in the equilibrium
level of output and
the equilibriuminterest rate.
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Tax cut and Economic Growth
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Can tax cut spur economic growth?
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Monetary Policy, Activity,
and the Interest Rate
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Monetary contraction, or monetary tightening,refers to a decrease in the money supply.
An increase in the money supply is called monetaryexpansion.
Monetary policy does not affect the IScurve, only theLMcurve. For example, an increase in the moneysupply shifts the LMcurve down.
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Monetary Policy, Activity,
and the Interest Rate
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Monetary expansionleads to higher outputand a lower interestrate.
The Effects of aMonetary Expansion
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Using a Policy Mix
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The combination of monetary and fiscal polices isknown as the monetary-fiscal policy mix, or simply,the policy mix.
The Effects of Fiscal and Monetary Policy.
Shift of ISShift of
LMMovement of
OutputMovementin Interest
Rate
Increase in taxes left none down down
Decrease in taxes right none up up
Increase in
spending
right none up up
Decrease inspending
left none down down
Increase in money none down up down
Decrease in money none up down up