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Diploma Macro Paper 2
Monetary Macroeconomics
Lecture 3
Aggregate demand:
Investment and the IS-LM model
Mark Hayes
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Outline
Introduction
Map of the AD-AS model
This lecture, continue explaining the AD curve
Last time, Step 1: Equilibrium with variable income and consumption – the Keynesian Cross
Step 2: Equilibrium with variable income, consumption and investment – the IS-LM model
This lecture highly theoretical, we look at the data with the help of the model next time
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Goods marketKX and IS
(Y, C, I)
Moneymarket (LM)
(i, Y)
IS-LM(i, Y, C, I)
AD
Labour market(P, Y)
ASAD-AS
(P, i, Y, C, I)
Phillips Curve(,u)
Foreign exchange market(NX, e)
AD*-AS(P, e, Y, C, NX)
Exogenous: M, G, T, i*, πe
IS*-LM*(e, Y, C, NX)
AD*
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Goods marketKX and IS
(Y, C, I)
Moneymarket (LM)
(i, Y)
IS-LM(i, Y, C, I)
AD
Labour market(P, Y)
ASAD-AS
(P, i, Y, C, I)
Phillips Curve(,u)
Foreign exchange market(NX, e)
AD*-AS(P, e, Y, C, NX)
Exogenous: M, G, T, πe
IS*-LM*(e, Y, C, NX)
AD*
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The IS curve
Definition: a graph of all pairs of i and Y that result in goods market equilibrium
i.e. value of output Y = expected expenditure E
Expected consumption C is an increasing function of income Y, as in the Keynesian Cross
PLUS: Expected investment I is now a decreasing function of the money rate of interest i
The equation for the IS curve is:
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Money and real interest rates
Mankiw uses r to mean both nominal (money) and real interest rates. This confuses the Classical and Keynesian models.
In a monetary model, only the money rate (i) exists as a causal variable.
The real interest rate only exists in a corn model.
What does exist in a monetary model is the expected rate of inflation e. This is exogenous here.
Investment depends on i - e
For clarity always use i in a monetary model
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A note on curve shifting
A curve (or line) in a diagram is a relationship between two endogenous variables
Movement along the curve shows how one variable changes if the other does
We are mainly interested in comparing equilibrium positions, how the point of intersection moves
A change in an exogenous variable shifts a curve, which moves the equilibrium position
Movement along a curve only happens in disequilibrium and may not be realistic
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The investment demand curve
i
I
I (i)
Spending on investment goods is a downward-sloping function of the interest rate
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The investment demand curve
i
I
I (i, e2)
I (i, e1)
e2 > e1
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Y2Y1
Y2Y1
Deriving the IS curve
i I
Y
E
i
Y
E =C +I (i1 )+G
E =C +I (i2 )+G
i1
i2
E =Y
IS
I E
Y
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Y2Y1
Y2Y1
Shifting the IS curve: G
At any value of i, G E Y
Y
E
i
Y
E =C +I (i1 )+G1
E =C +I (i1 )+G2
i1
E =Y
IS1
The horizontal distance of the IS shift equals
IS2
…so the IS curve shifts to the right.
1
1 MPC
Y G Y
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Shifting the IS curve: T
Y2
Y2
At any value of i, T C E E =C2 +I (i1 )+G
IS2
The horizontal distance of the IS shift equals
Y
E
i
Y
E =Y
Y1
Y1
E =C1 +I (i1 )+G
i1
IS1
…so the IS curve shifts to the left.
MPC
1 MPCY T Y
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The short-run equilibrium: IS-LM
Y
i
IS
LM
Equilibriuminterestrate
Equilibriumlevel ofincome
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The money market
What determines the money interest rate?
NOT the supply and demand for loanable funds!
In the monetary model, the interest rate clears the money market, matching the supply and demand for a stock of money
In the Classical model, the interest rate clears the loanable funds market, matching the supply and demand for flows of saving for investment
Oil and water!
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Money supply
The supply of
real money balances is fixed: sM P M P
M/P real money
balances
sM P
M P
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The demand for money
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Money demand (holding Y constant)
Demand forreal money balances:
M/P real money
balances
sM P
M P
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Equilibrium (holding Y constant)
The interest rate adjusts to equate the supply and demand for money:
M/P real money
balances
sM P
M P
¿¿
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Central Bank can raise the interest rate
To increase , CB reduces M
M/P real money
balances
interestrate
1M
P
1
2
2M
P
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The LM curve
The LM curve is a graph of all
combinations of i and Y that equate the supply and demand for real money balances.
The equation for the LM curve is:
¿¿
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Deriving the LM curve
M/P
i
1M
P
L (i ,
Y1 )
i1
i2
i
YY1
i1L (i , Y2 )
i2
Y2
LM
(a) The market for real money balances (b) The LM curve
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How M <0 shifts the LM curve
M/P
i
1M
P
L (i , Y1 ) i1
i2
i
YY1
i1
i2
LM1
(a) The market for real money balances (b) The LM curve
2M
P
LM2
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The short-run equilibrium: IS-LM
The short-run equilibrium
is the combination of i and Y that simultaneously satisfies the equilibrium conditions in the goods & money markets:
Y
i
IS
LM
Equilibriuminterestrate
Equilibriumlevel ofincome
𝒀=𝒄𝟏(𝒀 −𝑻 )+𝑰 (𝒊 )+𝑮
¿¿(IS)
(LM)
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Y1Y2
Deriving the AD curve
Y
i
Y
P
IS
LM(P1)
LM(P2)
AD
P1
P2
Y2 Y1
i2i1
Intuition for slope of AD curve:
P (M/P )
LM shifts left
i
I
Y
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Summary
We have derived the AD curve as a set of pairs of P and Y consistent with simultaneous equilibrium in the goods and money markets
The building blocks of the AD curve are the Keynesian Cross and the IS-LM model
We now have four endogenous variables:
Y, C, I and i
Exogenous variables include P, M, G and T
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Next time
Applying the IS-LM model:– Fiscal policy
– Monetary policy
Revise this lecture and make sure you understand how the model works before the next lecture!
Especially: consider the meaning of different slopes of the IS and LM curves