Department

Economics for Management StudiesCourse Code

MGEB06H3Professor

Iris AuLecture

11This

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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 = (α/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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