# MGEB06H3 Lecture Notes - Lecture 1: Ope, Keynesian Cross, M-Theory

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Review of IS/LM Model (Chapters 10 & 11)

IS Curve LM Curve

Ceteris paribus, the Investment Saving or IS

Curve shows all of the (Y,r) pairs that

support (lead to) equilibrium in the Goods and

Services market.

( i.e. YS = YD S = I )

Ceteris paribus, the Liquidity Market or LM

Curve shows all of the (Y,r) pairs that

support (lead to) equilibrium in the Money

(Asset) market.

( i.e. MS = MD AssetD = AssetS )

Keynesian Cross

Short-Run (SR) Equilibrium output (Y*SR)

is determined by equating planned

expenditure (E = YD) to actual expenditure

(Y = YSSR) GIVEN among other things fiscal

policy (i.e. G & T) and the real interest rate

(thus I is fixed).

Theory of Liquidity Preference

The real interest rate varies to determine

equilibrium in the money/assets market

GIVEN output (Y); the money supply (MS);

the aggregate or average price level (P); and

the real money demand curve L(Y,r).

In essence, the IS Curve combines the

interaction between r and I expressed by the

investment function and the interaction

between I and Y demonstrated by the

Keynesian cross.

Having r rise (fall) shifts E down (up) thereby

decreasing (increasing) Y*SR.. This traces out

the IS Curve as downward sloping.

Money market equilibrium implies all asset

markets are in equilibrium. Walras’ Law

states that if all but one market is in

equilibrium then the last market is also.

Therefore, consider assets as consisting of

two types monetary (money) and non-

monetary assets then MS = MD AssetD =

AssetS.

Having Y rise (fall) shifts the real money

demand function ( L(Y,r) ) up (down) thereby

increasing (decreasing) r*SR. This traces out

the LM Curve as upward sloping.

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IS Curve LM Curve

Algebraic Solution

NX = 0 Closed economy

C = C0 + C1( Y - T ) Consumption Function

I = I0 - I1r Investment Function

G = G0 Exogenous FP

(spending policy)

T = T0Exogenous FP (tax

policy)

Y = C + I + G NII

IS Curve

Y = [ 1/(1-C1) ][ C0 + I0 + G0 - C1T0 ]

- ( I1/(1-C1) )r

derived/drawn for: C0, I0, G0, T0, C1 & I1

given, fixed or exogenous

Y-axis intercept:

Y = [ 1/(1-C1) ][ C0 + I0 + G0 - C1T0 ]

r-axis intercept:

r = [ C0 + I0 + G0 - C1T0 ]/I1

IS Slope: δr/δY = - (1-C1)/I1 < 0

Algebraic Solution

Md = P( kY - hr ) Nom money

demand

Md/P = kY - hr Real money

demand

MS = M0Exogenous MP (exog.

nominal money supply)

P = P0Exogenous or fixed P level

MS = Md or MS/P = Md/P

LM Curve

Y = (1/k)(M0/P0) + ( h/k )r

derived/drawn for: M0S, P0, k & h given,

fixed or exogenous

Y-axis intercept:

Y = (1/k)(M0/P0)

r-axis intercept:

r = ( -1/h )(M0/P0)

LM Slope: δr/δY = k/h > 0

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