IS - LM model

IS - LM model

1. The goods market and the IS curve

   • the Keynesian Cross: a simple closed economy model in which income is determined by expenditure, difference between actual & planned expenditure = unplanned inventory investment
     • Fiscal policy and the multiplier: When the government imposes expansionary fiscal policy by increasing G, PE increases, the PE curve shifts upward => Y increases
       • when the government imposes contractionary fiscal policy by increasing tax (T), consumption decreases, PE decreases, the PE curve shifts downward => Y increases
     • actual expenditure: Y = real GDP, planned expenditure: PE = C + I + G, equilibrium condition: actual expenditure = planned expenditure => Y = PE
   • The IS curve: a graph of all combination of r and Y that result in goods market equilibrium
     • Shifting the IS curve: the IS curve is drawn for a given policy, in general: other predetermined variables that increase planned expenditure will shift the IS curve to the right

2. The money market and the LM curve

   • The theory of liquidity preference
     • In this chapter, money quantity is real variable (M/P). So, Money demand and money supply do not belong to Price or value of money
     • Money demand: is determined by interest rate (r) and income (Y), r increases -> MD decreases, Income (Y) increases -> MD increases
     • In the money market, the central bank reduces money supply -> MS curve shifts left => interest rate increases
     • In the goods market, interest rate increases -> investment decreases --> AD falls, AD curve shifts left => P and Y fall
   • The Lm curve
     • Reasons for the LM curve is upward sloping: An increase in income raises money demand, the interest rate must rise to restore equilibrium in the money market,...
     • A decrease in money supply (Y not change) -> r increase => the LM curve shifts left ward
     • The LM curve is drawn for a given supply of real money balances: increases in the supply of real money balances shifts the LM curve rightward
     • An increase in money demand (not because of Y,r) -> the LM curve shifts leftward

3. IS - LM model

   • The equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods & markets
   • An increase in government purchases (G increases) -> PE increases => IS curve shifts right 1/(1-MPC) x G
   • Increases in income (Y) raises money demand, causing excess of money demand => the interest rate rises
   • An increase in MS shifts the LM curve to the right, interest rate fall
   • r decrease -> investment increases -> PE increases -> output, income rises
   • IS shocks: exogenous changes in the demand for goods and services
   • LM shocks: exogenous changes in the demand for money