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Economics for Management Studies
Jack Parkinson

Review of IS/LM Model (Chapters 10 & 11) IS Curve LM Curve Ceteris paribus, the Investment Saving or IS Ceteris paribus, the Liquidity Market or LM Curve shows all of the (Y,r) pairs that Curve shows all of the (Y,r) pairs that support (lead to) equilibrium in the Goods and support (lead to) equilibrium in the Money Services market. (Asset) market. S D S D D S ( i.e. Y = Y ↔ S = I ) ( i.e. M = M ↔ Asset = Asset ) Keynesian Cross Theory of Liquidity Preference Short-Run (SR) Equilibrium output (Y* ) SR The real interest rate varies to determine is determined by equating planned equilibrium in the money/assets market expenditure (E = Y ) to actual expenditure GIVEN output (Y); the money supply (M ); S (Y = Y SSR) GIVEN among other things fiscal the aggregate or average price level (P); and policy (i.e. G & T) and the real interest rate the real money demand curve L(Y,r). (thus I is fixed). In essence, the IS Curve combines the Money market equilibrium implies all asset interaction between r and I expressed by the markets are in equilibrium. Walras’ Law investment function and the interaction states that if all but one market is in between I and Y demonstrated by the equilibrium then the last market is also. Keynesian cross. Therefore, consider assets as consisting of two types monetary (money) and non- monetary assets then M = M ↔ Asset = D Asset . Having r rise (fall) shifts E down (up) thereby Having Y rise (fall) shifts the real money decreasing (increasing) Y* SR.his traces out demand function ( L(Y,r) ) up (down) thereby the IS Curve as downward sloping. increasing (decreasing) r*SR This traces out the LM Curve as upward sloping. 1 IS Curve LM Curve Algebraic Solution Algebraic Solution NX = 0 Closed economy d M = P∗( k*Y – h*r ) Nom money demand C = C +0C ( 1 - T ) Consumption Function M /P = k∗Y – h*r Real money I = I0- I1∗r Investment Function demand G = G 0 Exogenous FP M = M Exogenous MP (exog. 0 (spending policy) nominal money supply) T = T Exogenous FP 0 P = P 0 Exogenous or fixed P level (tax policy) S d S d Y = C + I + G NII M = M or M /P = M /P IS Curve LM Curve Y = [ 1/(1-C )1]∗[ C +0I + 0 - C 0T ] 1 0 Y = (1/k)∗(M /P0) +0( h/k )∗r - ( 1 /(1-C1) )∗r IS is derived/drawn for: given, fixed or LM is derived/drawn for: given, fixed or exogenous, levels of C , 0 , 0 , 0 , 0 & 1 1 exogenous, levels of M , P0, k 0 h Y-axis intercept: Y-axis intercept: Y = [ 1/(1-C )1]*[ C +0I + 0 - C0∗T ]1 0 Y = (1/k)∗(M /P0) 0 r-axis intercept: r-axis intercept: r = [ C0+ I 0 G -0C ∗T1]/I0 1 r = ( -1/h )∗(M 0P 0 IS Slope: δr/δY = - (1-C )/1 < 1 LM Slope: δr/δY = k/h > 0 2 IS Curve LM Curve IS shifts (parallel) up & right if: either C ; 0 LM shifts (parallel) down & right if: either I0; or G0increases; or if T 0ecreases. M 0ncreases; or P de0reases. i.e. if autonomous expenditures increases i.e. if (M /P) increases for some reason (taxes represent negative autonomous expenditures). IS shifts and tilts (becomes steeper) if: LM shifts and tilts (becomes flatter) if: C falls. h increases. 1 i.e. the marginal propensity to consume falls i.e. if (M /P) decreases due to an increase in the sensitivity of real money demand to (changes in) the real interest rate 3 IS Curve LM Curve IS tilts up & right (becomes steeper) if: LM tilts down & right (becomes flatter) if: I1decreases. k decreases. i.e. the sensitivity of investment to the real i.e. if (M /P) decreases due to a decrease in interest rate decreases (which also makes the the sensitivity of real money demand to IS curve less interest rate sensitive, that is, (changes in) real income (GDP) [This is an steeper) increase iS velocity (V) which acts the
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