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Lecture 11

MGEB06H3 Lecture Notes - Lecture 11: Loanable Funds, Autarky, Supply Shock


Department
Economics for Management Studies
Course Code
MGEB06H3
Professor
Iris Au
Lecture
11

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Summary of the Various Shocks & How they Shift Curves in the
IS/LM and AS/AD Models
IS Curve
The IS curve plots all the (r,Y) points such that the goods market is in equilibrium. Since we are
investigating a closed economy goods market equilibrium occurs when the loanable funds
market is in equilibrium (I.e. investment equals saving, I = S, implies the supply of output equals
the demand for output, Y = C + I + G). So the IS curve also plots all the (r,Y) points such that
investment equals savings.
Closed economy NX = 0
Consumption Function C = C0 + C1•( Y - T )
Investment Function I = I0 - I1•r
Gov’t spending policy G = G0 Exogenous FP (spending policy)
Tax policy T = T0 Exogenous FP (tax policy)
National Income Identity Y = C + I + G Supply of output = Demand for output
Substituting all of these assumed terms into the NII yields the following IS curve equation:
Y = [ 1/(1-C1) ]•[ C0 + I0 + G0 - C1•T0 ] - ( I1/(1-C1) )•r
Which has been derived/drawn for given (fixed or exogenous) values of: C0, I0, G0, T0, C1 & I1
If we define the following: α = [ 1/(1-C1) ]•[ C0 + I0 + G0 - C1•T0 ]
α1 = ( I1/(1-C1) )
then the IS curve is: Y = α – α1•r or, r = (α1) (1/α1)•Y
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LM Curve
The LM curve plots all the (r,Y) points such that the money market is in equilibrium.
Nominal money demand Md = P•( k•Y - h•r ) , where k & h are positive constants
Real money demand ( Md/P ) = k•r - h•r
Nominal money supply MS = M0 Exogenous MP (nom money supply)
Nominal price level P = P0 Exogenous (i.e. fixed) P level
Money market equilibrium MS = Md or MS/P = Md/P
Yields the LM curve equation Y = (1/k)•(M0/P0) + ( h/k )•r
Which has been derived/drawn for fixed (i.e. given or exogenous) values of: M0S, P0, k & h
Alternatively, the LM curve can be written down as: r = (k/h)•Y (1/h)•(M/P)
Short-Run IS/LM Equilibrium
The SR equilibrium occurs where the IS and LM curves intersect.
Equating the two versions of the IS & LM curves written down in the form “Y equals ..” allows
us to solve for the SR equilibrium level of the real rate of interest r*.
IS = LM
α α1•r = (1/k)•(M0/P0) + ( h/k )•r
r•( (h/k) + α1 ) = α – (1/k)(M/P)
1
*
1
k
h
P
M
k
rSR
We can plug this SR equilibrium value of r into the IS curve (or LM curve) to obtain the SR
equilibrium value for real output Y. Alternatively, we can equate the two versions of the IS &
LM curves written down in the form “r equals ..” to solve for the SR equilibrium level of real
output Y*.
IS = LM
(α/α1) (1/α1)•Y = (k/h)•Y – (1/h)•(M/P)
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