Principles of Economics

Session 14

Topics To Be Covered

Equilibrium of the Goods MarketEquilibrium of the Money MarketThe IS-LM ModelThe AS-AD Model

The Big Picture

Liquid PreferenceKeynesian Cross

IS Curve LM Curve

AS-AD Model

Explanation of Short-Run Fluctuations

IS-LM Model

The Keynesian Cross

Demand

45°

Output=Demand

Output

Dem

and

0

Equilibrium of the Goods Market

Unplanned Inventory: $0 Income: $1000

Planned Saving:

$200

Planned

Inve

ntory

=

Planned

Inve

stmen

t: $2

00Planned Consum

ption: $800

Planned Expenditure = AD: $1000

Ou

tput

= A

S: $

1000

I200

S

Demand

45°

Equilibrium of the Goods Market

Output1000

1000

1000

Dem

and

(Pla

nn

ed E

xpen

dit

ure

)

0

0

Pla

nn

ed S

avin

g an

d

Inve

stm

ent

Output

Output=Demand, so the goods market is at equilibrium.

I = S

Contraction of the Goods Market

Unplanned Inventory: $200 Income: $1000

Planned Saving:

$400

Planned

Inve

ntory

=

Planned

Inve

stmen

t: $2

00Planned Consum

ption: $600

Planned Expenditure = AD: $800

Ou

tput

= A

S: $

1000

I200

S

Demand

45°

Contraction of the Goods Market

Output

Dem

and

(Pla

nn

ed E

xpen

dit

ure

)

0

0

Pla

nn

ed S

avin

g an

d

Inve

stm

ent

Output1000

400

1000

800

Output ＞Demand, so the goods market

tends to contract.

S ＞ I

Equilibrium output

Expansion of the Goods Market

Unplanned Inventory: - $200 Income: $1000

Planned Saving:

$0

Planned

Inve

ntory

=

Planned

Inve

stmen

t: $2

00Planned Consum

ption:$1000

Planned Expenditure = AD: $1200

Ou

tput

= A

S: $

1000

I200

S

Demand

45°

Expansion of the Goods Market

Output

Dem

and

(Pla

nn

ed E

xpen

dit

ure

)

0

0

Pla

nn

ed S

avin

g an

d

Inve

stm

ent

Output

1000

1200

Equilibrium output

1000

Output ＜Demand, the goods market

tents to expand.

S ＜ I

Equilibrium of the Goods Market

GDPPlanned

ConsumptionPlanned Saving

Planned Investment GDP

Total PlannedC and I

Resulting Tendency of Output

1000 600 400 200 1000 800 Contraction

1000 800 200 200 1000 1000 Equilibrium

1000 1000 0 200 1000 1200 Expansion

＞＝＜

When the goods market is at equilibrium, planned investment equals planned saving.

The IS Curve

The IS curve is a graph of all combinations of interest (r) and output (Y) that result in goods market equilibrium.

When the goods market is at equilibrium

Output=Planned Expenditure

Planned Investment = Planned Saving

Deriving the IS curve

Y

E

r

Y

E1 =C +I (r1 )+G

r1

E =Y

IS Curve

E2 =C +I (r2 )+G

I

E

Y

r I

Y1

Y1

r2

Y2

Y2

Deriving the IS Equation

I = investment r = interest rate e ＞ 0, d ＞ 0

dreI ＝

dreGCGdreC

GICY

)()(

Ydd

eGCr

1

The Downward-Sloping IS Curve

A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending.

To restore equilibrium in the goods market, output must increase.

Output increases

Interest rate falls

Investment spending increases

The Downward-Sloping IS Curve

dreGCY )(

Ydd

eGCr

1

Fiscal Policy and the IS Curve

At any value r, increase in government purchase (G) results

in more expenditure and consequently more output (Y),

so the IS curve shifts to the right.

Fiscal Policy and the IS Curve

Y

E

r

Y

E1 =C +I +G1

r1

E =Y

IS1

E2 =C +I +G2

G

Y1

Y1

IS2

Y2

Y2

YMPC

GY

1

1

The Demand for Money(The Liquid Preference)

Transaction demand for moneyThe needs or desires of individuals or firms to make purchases on short notice without incurring excessive costs.

Speculative demand for moneyAn attitude that holding money over short periods is less risky than holding stocks or bonds.

The Transaction Demandfor Money

The transactions demand for money is based on the desire to facilitate transactions.

It mainly depends on the income, so its function is:

) (Y L L1 1

The Speculative Demandfor Money

The speculative demand for money is based on the desire to make wise decisions to invest in securities such as bonds.

It mainly depends on the interest, so its function is:

) (r L L2 2

The Speculative Demandfor Money

When the interest is high, the bond price is low. Usually people will guess that the bond price is to rise, so they purchase bonds, thus having less money in hand.

Lessmoneyin hand

highinterest

rates

Purchasingbonds

Lowbondprices

The Speculative Demandfor Money

When the interest is low, the bond price is high. Usually people will expect that the bond price is to fall, so they sell the bonds they own. Consequently they have more money in hand.

Moremoneyin hand

Lowinterest

rates

Sellingbonds

Highbondprices

Demand for Money

hr kY r L Y L L L L ) ( ) (2 1 2 1

m

rL1=L1(Y)

L2=L2(r)

m

r

L=L1+ L2

Equilibrium of the Money Market

L m When the money market is at equilibrium,

the demand for money (L) should be equal to the supply of money (m).

The money supply is controlled by the central bank.

Equilibrium of the Money Market

m

rL

m1

m1

r1E

When money demand and supply equal, the money

market is at equilibrium

The LM Curve

The LM curve is a graph of all combinations of interest (r) and output (Y) that result in money market equilibrium.

When the money market is at equilibrium, the demand for and the supply of real money balances.

hr kY L m

Deriving the LM Curve

m1 m

rL1

r1 E1

Y

r

r1 E1

Y1 Y2

L2

r2 E2

LM Curve

The Market for Real Money

Balances

The LM Curve

r2 E2

Deriving the LM Equation

m = supply of real money r = interest rate k ＞ 0, h ＞ 0

hrkYm ＝

rk

h

k

mY

Yh

k

h

mr

The Upward-Sloping LM Curve

An increase in income raises money demand. Since the supply of real balances is fixed, there is now excess demand in the money market at the initial interest rate.

The interest rate must rise to restore equilibrium in the money market.

Interest raterises

Outputincreases

Demand for money increases

The Upward-Sloping LM Curve

rk

h

k

mY

Yh

k

h

mr

Monetary Policy andthe LM Curve

At any value r, increase in output requires more money supply to

maintain the interest rate constant, so the LM curve shifts

to the right.

Monetary Policy and the LM Curve

m1 m

rL1

r1 E1

Y

r

r1 E1

Y1 Y2

L2 LM1

The Market for Real Money

Balances

The LM Curve

E2

LM2

E2

m2

The IS-LM Model

The IS-LM model is a graph showing the short-run equilibrium

with the combination of r and Y that simultaneously satisfies the

equilibrium conditions in the goods and money markets.

The IS-LM Model

Y

r

E

Equilibrium output

LM

IS

Equilibrium interest

rate

The IS-LM Model

Y

r

E

Equilibrium output

LM

IS

Equilibrium interest

rate

A

BC

D

F

G

For A, B, and C,

I ＜ S.

For D, F, and G,

I ＞ S.

The IS-LM Model

Y

r

E

Equilibrium output

LM

IS

Equilibrium interest

rate

AB

C DF

G

For A, B, and C,

L ＜ M.

For D, F, and G,

L ＞ M.

The IS-LM Model

Y

r

E

Equilibrium output

LM

IS

Equilibrium interest

rate

L ＜ MI ＜ S

L ＞ MI ＞ S

L ＜ MI ＞ S

L ＞ MI ＜ S

The Policy and the IS-LM Model

Policymakers can affect macroeconomic variables with

fiscal policy: G and/or T

monetary policy: M

The IS-LM model can be applied to analyze the effects of these policies.

The Fiscal Policy andthe IS-LM Model

IS1 Y

r

LM

r1

Y1

IS2

Y2

r2

The Monetary Policy andthe IS-LM Model

ISY

r

LM1

r1

Y1

LM2

Y2

r2

Interaction between Monetary and Fiscal Policy

Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa.

Such interaction may alter the impact of the original policy change.

Monetary Policy in Response to Fiscal Policy

Suppose the government increases G.Possible central bank’s responses:

hold M constant hold r constant hold Y constant

In each case, the effects of the G are different.

Response 1: Hold M Constant

IS1

Y

r

LM1

r1

Y1

IS2

Y2

r2

Response 2: Hold r Constant

IS1

Y

r

LM1

r1

Y1

LM2

IS2

Y2

r2

Y3

Response 3: Hold Y Constant

IS1

Y

r

LM1

r1

Y1

LM2

IS2

Y2

r2

r3

Keynesian Trap

LM

Y

r

IS2IS1

IS4

IS3

Keynesian trap or liquid preference trap, over where

fiscal policy works most efficiently

Classical situation where fiscal policy

has no positive effect.

Deriving the AD curve

Y

r

Y

P

IS

LM(P1)

AD

P1

r1

Y1

Y1

P2

LM(P2)

r2

Y2

Y2

r

P (M/P)

I

Y

LM

Monetary Policy and AD Curve

Y

r

Y

P

IS

AD1

P1

LM(M1/P1)

LM(M2/P1)r1

r2

Y1

Y1

r

M LM

I

Y at each P

Y2

Y2

AD2

Fiscal Policy the AD curve

Y

r

Y

P

IS1

AD1

P1

LM

r1

r2

Y1

Y1

G IS

Y at each P

Y2

Y2

AD2

IS2

The Downward-Sloping AD Curve

The aggregate demand curve slopes downward for three reasons: The wealth effect The interest-rate effect The exchange-rate effect

The Wealth Effect

A decrease in the price level increases the purchasing power of nominal money, thus making consumers feel more wealthy and in turn spend more.

The increased consumption raises AD. Pigou Effect

LevelPrice

Wealth NominalWealth Real

The Interest Rate Effect

A lower price level increases the supply of real money, which reduces the interest rate and in turn encourages investment.

The increased investment raises AD. Keynesian Effect

(P) LevelPrice

(M) Supply Money Nominal(m) Supply Money Real

The Exchange-Rate Effect

When a fall in the domestic price level causes domestic interest rates to fall, the real exchange rate depreciates, which stimulates net exports.

The increased net export raises AD. Mundell-Flemming Effect

The AS Curve

In the long run, the aggregate-supply curve is vertical.

In the short run, the aggregate-supply curve is upward sloping.

The Upward-Sloping AS Curve

Y

PAS

P1

Y1

P2

Y2

The Upward-Sloping AS Curve

The upward-sloping short-run AS curve can be accounted for with the following theories:The Misperceptions TheoryThe Sticky-Wage TheoryThe Sticky-Price Theory

The Misperceptions Theory

Changes in the overall price level temporarily mislead suppliers about what is happening in the markets in which they sell their output: A higher price level causes misperceptions

about relative prices. These misperceptions induce suppliers to

increase the quantity of goods and services supplied.

The Sticky-Wage Theory

Nominal wages are slow to adjust, or are “sticky” in the short run: Wages do not adjust immediately to a rise in

the price level. A higher price level makes employment

and production more profitable. This induces firms to increase the quantity of

goods and services supplied.

The Sticky-Price Theory

Prices of some goods and services adjust sluggishly in response to changing economic conditions: An unexpected rise in the price level leaves

some firms with lower-than-desired prices. This increases sales, which induces firms to

increases the quantity of goods and services they produce.

Menu cost

The Vertical AS Curve

In the long-run, an economy’s production of goods and services depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services.

The price level does not affect these variables in the long run, so the AS curve is vertical.

The Vertical AS Curve

Y

P

Potential output

2. …does not affect the quantity of goods and services supplied in the long run.

P2

1. A change in the price level…

P1

AS

The Vertical AS Curve

The long-run aggregate supply curve is vertical at the potential output.

This level of production is also referred to as natural rate of output or full-employment output.

Shifting of the Vertical AS Curve

Any change in the economy that alters the natural rate of output shifts the long-run aggregate-supply curve.

The shifting of long-run AS curve may arise from the change of: Labor Capital Natural resources Technology knowledge

1. In the long-run, technological progress shifts long-run AS...

LRAS2000LRAS1990

Shifting of the Vertical AS Curve

Y

P

0

P1980

Y1980

AD1980

P2000

P1990

LRAS1980

2. …and growth in the money supply shifts AD...

AD2000

AD1990

4. …and ongoing inflation.

Y1990 Y2000

3. …leading to growth in output...

The AD-AS Model

Y

P

0

Short-run AS

AD

AEquilibrium price

Long-run AS

Potential Output

1. A decrease inaggregate demand…

AD2

The AD-AS Model

Output

PriceLevel

0

Short-run aggregatesupply, AS1

Long-runaggregate

supply

Aggregatedemand, AD1

AP1

Y1

BP2

Y2

2. …causes output to fall in the short run…

AS2

CP3

3. …but over time,the short-run aggregate-supply curve shifts…

4. …and output returnsto its natural rate.

From AE-NI, IS-LM to AD-AS

The AE-NI model (Keynesian cross) assumes that the interest and price level are constant. Thus, the multiplier effect is great.

The IS-LM model assumes that the price level is constant but that the interest rate is variable. Thus, the crowding out effect is taken into consideration.

The AD-AS model assumes that the interest rate and price level are variable.

From AE-NI, IS-LM to AD-ASThe expansionary fiscal policy will cause the

price level to rise. The rise of price level means the decrease of the real money supply, thus the interest rate is even higher. Thus the crowding-out effect is even greater when the price-level is considered in the context of AD-AS model.

Governmentpurchasesincrease

Crowding-out effectincreases

Pricelevel

increases

Real moneysupply

decreases

Interestraterises

Y

E

r

Y

E1 =C +I(r1)+G1

E1

IS1

Y1

LM1

Y2

Y2

Y2

r

Y

AD1

P1

AD2

E4

E4 =C +I(r3)+G2

Y1

Y1

E3 =C +I(r2)+G2

E3

AD3

AS1

Y3

Y3

Y3

Y4

Y4

Y4

E2 =C +I(r1)+G2

E2

IS2

r1

r2

P2

LM2r3

Assignment

Review Chapter 1—30.Go over handouts.Be alert to economic phenomena around

you and try to understand them with the help economic principles.

Apply what you’ve learned to your studies and life.

Thanks