A Presentation By : - Dhananjay Ghei 09HS2023 Abhishek Jadon 09HS2010
The Goods and The Money Market Equilibrium Equilibrium of the goods market is achieved when the goods market is cleared, i.e. , according to Keynes, planned saving is equal to planned investment. S=I OR Y=C+I Equilibrium of the money market requires equality between the supply of and the demand for money. Ms = Md
Equilibrium in the Goods Market In developing the IS model, investment is considered as a function of rate of interest , consumption and saving as functions of income. Investment Function : I = I(r) Consumption Function : C = C(Y) Saving Function : S = S(Y) Equilibrium in the goods market is achieved when :- S(Y) = I(r) However, this relationship may be shown graphically as follows
IS Curve Re-translation of Simple Keynesian model at equilibrium (Investment = Saving). A plot of equilibrium output for various interest rates within the market for goods and services.
Determining Output Note two characteristics of ZZ: Because it’s assumed that theconsumption and investmentRelations are linear, ZZ is,in general, a curverather than a line.ZZ is drawn flatter than a 45-degree line because it’sassumed that an increase inoutput leads to a less than onefor-one increase in demand.
Deriving the IS Curve Deriving the IS Curve(a) An increase in the interest ratedecreases the demand for goodsat any level of output, leading toa decrease in the equilibrium level ofoutput.(b) Equilibrium in the goods marketimplies that an increase in theinterest rate leads to a decrease inoutput.
Properties of IS Curve Downward Sloping, i C, I Y* Increase/Decrease in autonomous expenditure will shift the IS curve Rightward/Leftward. The steepness or flatness of the IS curve describes the elasticity or responsiveness of C and I to the nominal interest rate. -- Steep IS curve: inelastic. -- Flat IS curve: elastic.
Shifts in IS Curve due to taxes An increase in taxesshifts the IS curve tothe left.
Equilibrium in the Money Market Money Market Equilibrium is achieved when the supply of money and demand for money are equal. M s = Md Money Demand is made of two parts : - Msp : Speculative Demand for Money Mt : Transactionary Demand for Money Md = Msp + Mt
LM Curve Depicts equilibrium in the Money market (L = M), as well as the Bond Market (by Walras Law). A plot of the equilibrium interest rate for various levels of output or income, within the money market for a given level of the nominal money supply.
Deriving the LM Curve An increase in income rate. leads, at a given Equilibrium in the interest rate, to an financial markets increase in the implies that an demand for money. increase in income Given the money leads to an increase in supply, this increase the interest rate. The in the demand for LM curve is therefore money leads to an upward sloping. increase in the equilibrium interest
Properties of LM Curve Upward sloping, Y L i* Increase/Decrease in the real money supply shift the LM curve Rightward/Leftward. The steepness or flatness of the LM curve describes the elasticity or responsiveness of money demand (L) to the nominal interest rate. -- Steep LM curve: inelastic. -- Flat LM curve: elastic.
Shifts in LM Curve due to change inMoney Supply An increase in moneycauses the LM curveto shift down.
Two – Market Equilibrium The intersection point of the IS and LM curve denotes the equilibrium point between the two markets. There is only one combination of Y and r at which both the goods market and the money market are in equilibrium simultaneously.
Fiscal and Monetary policies Fiscal contraction, refers to fiscal policy that reduces the budget deficit. An increase in the deficit is called a fiscal expansion. Taxes affect the IS curve, not the LM curve. Monetary contraction, refers to a decrease in the money supply. An increase in the money supply is called monetary expansion. Monetary policy does not affect the IS curve, only the LM curve. For example, an increase in the money supply shifts the LM curve down.
Quiz In the IS side of the IS-LM model, the money market:a.) is implicit in the I curveb.)is completely absentc.) conditions equilibrium The goods market side of the IS-LM model is:a.)flow modelb.)stock modelc.) neither If I is highly sensitive to r then, graphically:a.) IS curve will be close to verticalb.) IS Curve will be close to horizontalc.) IS Curve will be impossible to draw
Quiz Equilibrium in the Goods Market occurs when:a.) I + G = S + Tb.) G = Tc.) S = T Graphically, a fall in G would:a.) shift IS rightwardb.) shift IS leftwardc.) make IS vertical The money market side of the IS-LM model is:a.) flow modelb.) stock modelc.)neither
Quiz Speculative demand for money is a function of:a.) rb.) Yc.) G In IS-LM model, money supply is:a.) endogenousb.)exogenousc.)irrelevant Since the velocity of money increases as interest rates rise the:a.) LM curve is positively slopedb.)LM curve is negatively slopedc.)IS curve is negatively sloped
Quiz A change in the publics desire to hold money will:a.) shift the LM curveb.) change the slope and position of LM Curvec.) change the slope of LM Curve When the central bank sells government bonds on the open market we have:a.) contractionary monetary policyb.) expansionary monetary policyc.) contractionary fiscal policyd.) expansionary fiscal policy
Quiz If the Congress passes wage and price controls in response to increased inflation we have had:a.) contractionary monetary policyb.) expansionary monetary policyc.) contractionary fiscal policyd.) expansionary fiscal policye.) none of the above The IS curve shows all combinations of income and:a.) interest rate for which the goods market is in equilibriumb.) interest rate for which the money market is in equilibriumc.)price level for which the goods market is in equilibriumd.)price level for which the money market is in equilibrium
Quiz In terms of the ISLM model, an increase in tax rates should move the:a.)IS curve leftb.)IS curve rightc.)LM curve rightd.)LM curve left The LM curve depicts Y,r combinations at which:a.) transactions and speculative demands are equalb.)transaction demand does not exceed speculative demandc.)money demand equals money supply
What happened in U.S. in 2001? The U.S. economy shrank in three quarters in the early 2000s (the 3rd quarter of 2000), the first quarter of 2001, and the third quarter of 2001. The US economy was in recession from March 2001 to November 2001, a period of eight months. 2.1 million people lost their jobs as unemployment rose from 3.9% to 5.8% . GDP growth slowed to 0.8% ( compared to 3.9% annual average growth during 1994-2000)
Causes of U.S Recession Stock Market Decline 1500 Standard & Poor’s 500 1200Index 900 600 300 1995 1996 1997 1998 1999 2000 2001 2002 2003 9/11 Attack on U.S.
Outcome of the Recession Increased Uncertainty. Fall in Consumer and Business Confidence.This all resulted in : - Lower Spending, IS curve shifted towards left. Reduced Stock Prices, Discouraged Investment
Measures taken Fiscal MeasureIS Curve shifts towards Right 1. Tax cuts in 2001 and 2003 2. Spending Increases a. Airline industry bailout b. Afghanistan War Monetary MeasureLM Curve shifts donwards towards Right. 1. Rise in interest rate 2. Depress Income
The U.S Recession with IS – LM Model The decrease in investment demand led to a sharp shift of the IS curve to the left, from IS to IS”. The increase in the money supply led to a downward shift of the LM curve, from LM to LM’. The decrease in tax rates and the increase in spending both led to a shift of the IS curve to the right, from IS’’ to IS’.
Conclusion IS Curve represents the equilibrium of the goods market. LM Curve represents the equilibrium of the money market. The point of intersection of the two curves is the point of equilibrium of both the markets simultaneously. By taking both fiscal and monetary measures using the IS – LM model recession can be checked out.
Refrences Books referred : - 1. Macroeconomic Analysis : - E. Shapiro 2. Macroeconomics : – N. Gregory Mankiw 3. An Inquiry into the Nature and Causes of the Wealth of Nations : - Adam Smith Online References : - 1. Wikipedia 2. Authorstream 3. IS – LM model by Dudley Cooke (Trinity College Dublin)