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Inventory drops
Inventory
• Equilibrium is at the point where Y accumulates.
= C + I + G.
E
Y=E
• If firms were producing at Y1 then Y
>E
E=C+I+G
• Because actual expenditure
exceeds planned expenditure,
inventory accumulates, stimulating E* MPC
a reduction in production.
£1
• Similarly at Y2, Y < E
Y
• Because planned expenditure Y2 Y* Y1
exceeds actual expenditure,
inventory drops, stimulating an
increase in production.
Investment, Sales (Y), and the Interest Rate (i)
I = I (Y , i )
The Goods Market and the IS Relation
Y = C (Y − T ) + I + G
The Determination of Output
Y = C(Y − T ) + I (Y , i ) + G
Equilibrium in the Goods Market
•Equilibrium in the
goods market implies
that an increase in the
interest rate leads to a
decrease in output.
The IS curve is
downward sloping.
Deriving the IS curve
•An increase
in taxes shifts
the IS curve
to the left.
What is the IS curve?
E=C+I(r1)+G
Let the interest rate E=C+I(r2)+G
This decrease in investment
increaseSo from
Y decreases
r1 to r2 reduce
from
The
causes
IS curve
the planned
maps out this ∆I
planned investment
Y1 to Y2. from
expenditure
relationship
function
between
to shift
the
I(r1) to I(r2).
interestdown.
rate, r, and output
(or income) Y. Y
Y2 Y1
r r
r2 r2
r1 r1
I(r) IS
I Y
I(r2) I(r1) Y2 Y1
While changing r allows us to map
E
out the IS curve, changes in G, T, E=Y
or MPC cause Y to change for any
level of r. This causes a shift in
the IS curve.
∆G
Suppose an increase in G
causes planned expenditure
to shift up by ∆G. Y
Y1 Y2
r
For any r the increase in G
causes an increase in Y of
∆G times the government
expenditure multiplier.
r1
Therefore, the IS curve IS´
shifts to the right by this IS
amount. Y
Y1 Y2
Financial Markets and the LM Relation
M = $YL(i )
M = nominal money stock
L(i) = demand for money
$Y = nominal income
i = nominal interest rate
Real Money, Real Income, and the Interest Rate
M
= YL(i )
P
Recall: before, we had the same equation but in nominal
instead of real terms (nominal income and nominal money
supply). Dividing both sides by P (the price level) gives us
the equation above.
Money Demand
(M/P)dd = L (r,Y)
(M/P) = L (r,Y)
•Equilibrium in
financial markets
implies that an
increase in income
leads to an increase
in the interest rate.
The LM curve is
upward-sloping.
What is the LM curve?
An increase
in money
causes the
LM curve to
shift down
A Financial Market Interpretation
b
r2
a
r1
IS
Y2 Y1
National income (Y)
Price level (P)
P2 b'
P1 a'
AD
Y2 Y1
Building the LM curve
The LM curve maps the
relationship between r
and Y for the money
market.
r r
(M/P)s
LM
r2 r2
r1 r1
L(r,Y1) L(r,Y2)
Real Y
Money Y1 Y2
Balances
Shifting the LM curve
While changing money demand allows us to map out the LM curve, changes in M or P
cause r to change for any level of Y. This causes a shift in the LM curve.
r (M2/P)s (M1/P)s r
LM´ LM
r2 r2
r1 r1
L(r,Y)
Real
Y
Money
Balances
Investment
• I = S + (T – G)
•A fiscal contraction may decrease investment.
Or, looking at the reverse policy, a fiscal
expansion—a decrease in taxes or an increase
in spending—may actually increase
investment.
Fiscal Policy, the Interest Rate and the IS Curve
Shifting of IS and LM
Using a Policy Mix
IS relation: Y = C(Y − T ) + I (Y , i ) + G
•Equilibrium in the goods market
M
implies that an increase in the LM relation: = YL(i )
P
interest rate leads to a decrease in
output. Equilibrium in financial
markets implies that an increase
in output leads to an increase in
the interest rate. When the IS
curve intersects the LM curve,
both goods and financial markets
are in equilibrium.
LM(P2)
AD from IS-LM LM(P1)
1. Price levels are LM(P0)
r2
increased, with P0<P1<P2.
r1
2. LM shifts to the left with r0
increasing P because real
money balances decline. IS
3. Interest rates rise.
4. Investment and durable Y2 Y1 Y0 Y
goods expenditures fall
as interest rates rise.
5. Plot price levels against P2
the resulting output (Y)
levels. P1
7. Thus AD is embedded in P0
the logic of IS-LM.
AD
Y1 Y0
Thank You for your Attention
☺
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