# ECO202Y5 Chapter Notes - Chapter 5: Exogeny, Open Market Operation, Disposable And Discretionary Income

by OC2183280

Department

EconomicsCourse Code

ECO202Y5Professor

Michael HoChapter

5This

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Chapter 5 – Goods & Financial Markets: The IS-LM Model

Chapter 5 – Goods & Financial

Markets: The IS-LM Model

Goods Market and IS Relation; Financial Markets and LM Relation; IS-LM Model; Using

Policy; LM Relation When the Central Bank Directly Targets the Interest Rate

5-1: THE GOODS MARKET AND THE IS RELATION

Summary of Chapter 3

o Equilibrium in the goods market: Y = Z

o The equality of demand and production is called the IS relation because it has been historically

reinterpreted as the equality of I (investment) and S (saving).

o Z = C + I + G

o Consumption is a function of disposable income (income minus taxes). We took I, G, and T as

given. Equilibrium condition was given by:

=( − )++

Previously, we had 2 simplifications: (1) interest rates do not affect demand, and (2) exports &

imports were 0. In this chapter, we will remove the first simplification.

Investment, Sales, and the Interest Rate

Investment depends primarily on 2 factors:

o Level of Sales. A firm facing an increase in sales needs to increase production.

o Interest Rate. When a firm needs to buy a new machine (invest), the firm must borrow either by

taking a loan or issuing bonds. The higher the interest rate, the less likely the firm is to borrow.

To capture these two effects, we write the investment relation as follows:

=(,)

(+, −)

The IS Curve

Considering the investment relation, the equilibrium condition in the goods market becomes:

=( − )+(,)+

Equilibrium is reached at the point where demand equals production, at point A—the intersection of

ZZ and the 45° line. The equilibrium level of output is given by Y. Suppose the interest rate increases

exogenously. At any level of output, investment decreases. ZZ shifts down. Equilibrium is now Y '.

The initial decrease in investment leads to a larger decrease in output through the multiplier effect.

Using ZZ, we can find the equilibrium value of output associated with any value of the interest rate.

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Chapter 5 – Goods & Financial Markets: The IS-LM Model

Generally, equilibrium in the goods market implies that the higher the interest rate, the lower is the

equilibrium level of output. This relation between the interest rate and output is represented by the

downward-sloping curve called the IS curve.

Shifts in the

IS

Curve

Consider an increase in taxes. At a given interest rate, consumption decreases, leading to a decrease

in the demand for goods and (through the multiplier) to a decrease in equilibrium output. The IS

curve shifts to the left: at any interest rate, the equilibrium level of output is lower than before.

Generally, any factor that (for a given interest rate) decreases the equilibrium level of output, leads

the IS curve to shift to the left. Ex: decrease in G, decrease in consumer confidence.

The same is true of the opposite; increases in equilibrium level of output shifts the IS curve right.

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Chapter 5 – Goods & Financial Markets: The IS-LM Model

Summary

o Equilibrium in the goods market implies that output is a decreasing function of the interest rate.

o This relation is represented by the downward-sloping IS curve.

o Changes in factors that decrease or increase the demand for goods given the interest rate shift the

IS curve to the left or to the right.

5-2: FINANCIAL MARKETS AND THE LM RELATION

The interest rate is determined by the equality of the supply and demand of money.

= $ ()

M is the nominal money supply. The right side is the demand for money, which is a function of

nominal income ($Y) and the nominal interest rate i. An increase in the nominal income increases the

demand for money, and an increase in the interest rate decreases the demand for money.

Real Money, Real Income, and the Interest Rate

Recall that nominal income divided by the price level equals real income, Y. Dividing both sides of

the equation by the price level P gives:

= ()

This is the LM relation. The real money supply equal to the real money demand.

The LM Curve

Let the interest rate be measured on the vertical axis and (real) money be measured on the horizontal

axis. Money supply is given by the vertical line at M/P and is denoted M s. Money demand is a

decreasing function of the interest rate (for a given level of income Y) and is, therefore, a downward-

sloping curve denoted M d.

Consider an increase in income, which increases demand for money at any given interest rate. Using

(a), we can find out the value of the interest rate associated with any value of income for a given

money supply.

Generally, equilibrium in financial markets implies that the higher the level of output, the higher the

demand for money and therefore the higher is the equilibrium interest rate. This relation between

output and the interest rate is represented by the upward-sloping curve called the LM curve.

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