ECO531 Chapter 8 IS-LM Model PDF

1 market product d 4 money 3 5 x market positive determinant M money demand income National IS LM Define . of determinants 2 . . 3 Chapter 8: THE ISLM MODEL IS Define . 2 Ms - relateda government control by I trice le it Explains how interest rate & (i) and total o...

1 market product d 4 money 3 5 x market positive determinant M money demand income National IS LM Define . of determinants 2 . . 3 Chapter 8: THE ISLM MODEL IS Define . 2 Ms - relateda government control by I trice le it Explains how interest rate & (i) and total output O (Y) in the economy. A:What is IS:- The relationship betweenOi and g Yfor which the goods market is in equilibrium. Panel A: show the Irote r/ship between i andy I spending - negative relationship . investment The lowesti The highest level of , ↑ it investment ↓ Investment T . instead saving buat I AP T Y = c+ X + G 1 t I - M import spending t 4 +Nx Y3Ct I3 + &t N 5 + X government expenditure Y AD ↑ X consumpti Y export investment X Panel B: The 3 levels of l are represented in AD function alan sbb , investment : Y ↓ 7 Panel C: 1S curve ilrate in y D ↓ in Y ↑ - - - ↑ in z - It 8 Ye Yyt --E ↑ downward like sloping demand Line connecting the 3 points in Panel C is referred to the IS curve curve -IS consumption ↑ , income 2y CIneome) Point 1 in panel C shows the resulting equilibrium of output Y, which corresponds to i:i As I rises to ia, both planned I spending falls to l. So, equilibrium output falls to Y2. Negative slope indicates the highest the i, the lowest the l. ↑ B:Different elasticity level of IS (a) Flat Irate AY> A is interest elastic IS Flat (6) Steep AY rate Iis interest inelastic IS Steep 15 CFactors that cause the IS curve to shift Assumption: i as a constant 1/ An t in autonomous 2/ An in Investment spending 3/ An t in Government 41 consumption expenditure (C) due to business Expenditure (G) Ain Taxes (T) optimism (1) All the factors will shift the IS curve to the right from IS to IS2 5/ An in NX unrelated to I (NX) and leads to increase in Y from r a Y to Y2. 152 Y D: What is LM: A curve that shows the relationship between nominal i and real income level (Y) for which the money market is in equilibrium. iis determined by equilibrium in the money market when the money demand (Md) equals to money Pg :146 supply (MS). Assume: Money Supply (MS) is fixed. Clrall (a) iraTe (6) M LM 3 (Md (VL) MdCY) Fall in real income Y3 Y2 causes Md to shift from Md(Y) to Md(Y2). So i mustfaill from i3 to i2 E:Different elasticity levelof LM: Slope of LM depends on the i elasticity of Md. (a) Md is steep (inelastic) M md trate md Y (b) Md is flat (elastic) (Trat Y steap - LM stoep The more elastic (flatter) Md, the flatter the LM curve. iml MS LM nd money m flat LM fiat 3 Factors that cause the LM curvetoshift 1/ An in nominal MS Assumption: t is come Income (Y) is Fixed from the actions impiemented by the Govemment such as by using OMO. LRR. Discount rate etc mS LM7 Shits the LM curveto the Right 2/An in,Md (Y) Assumption: Income is Fixed and; MS is Fixed LM Shifts the LM curve to the Leit 5:1Sd Y 3/An in Price level - tns Fixed Assumption: Income (Y) is Ln i r a l Lm P LM Shifts the LM curve to the Left r:s Y Equilibrium and Disequilibrium of theISLM Model Intersection point when IS and LM curves equal at point E. Goods Market Money Market IS =LM At any other points in the diagram (A, B, C, D), market forces will move the economy towards the general equilibrium, E Pa:152 i a t e LM y Changes inequilibriuminterestrate(i) and aggregate output(Y) Case: At Yo, the economy is suffering from 10% of unemployment rate (a) Response to a change in Monetary Policy Expansionary MP: increase in MS in T LM shifts to the Righit (b) Response to a change in Fiscal Policy Expansionary FP:/Increase in G or; decrease IS shifts to the Right L L 15 IS it:Y Po153 Pg:154 Effectiveness of MP inthe ISLM model Changes in Money (LM) Market (IS). will in turn effect real sector That is, the MP has an indirect impact on economic activity. The effectiveness of MP depends on 2 relationship: (a) (b) LM The interest elasticity of the demand for money The inerest elasticity of the investment function ><><><><><><><>< IS ><><><><><><><> xK>><><><><><><><><><><><>< ><><><><>< (a) The interest elasticity LMInelastic(steep): i LM of the demand for moneychanges in LM LM LM2Elastic; Lm Perfectly Elastic M2 Lm2 -LM3 Yo y mall Large change s in Y arqe A iny in y Small No any change change s in Y s in Y MP will be The flatter the LM, the less effective of the y Yy Yo change on the equilibrium level of income. (sS M LU 6 (b) The interest elasticity ofthe investment function changes in ISPerfectlyinelastic IS2Inelastic; ISElastic; IS ra IS3 UM M LM Lm 1S S2 Y y W Large change s in Y Less No any change change S in Y s in Y The steeper the IS, the less effective of the MP will be change on the equilibrium level of income. - 15 ess &FPin the ISLM model MP of effectiveness the on view Keynesian and Monetarist recession and unemployment. Need to choose which is the best one policy to recover economy from 1/ Keynesian LM curve is flat S Curve is steep Monetary Policy > LM MS in LM shifts - change (note: Expansionary MP rightward When MS, there will be will ( P of bonds) and i will . to LM1, i excess When i , This cost of borrowing . policy I greater than t in money market, thus in I. LM to Right) in Y. (Ms > Md). Then people will purchase bonds which Y, Ct, Y(1. in interest rate would lead to a greater changes (i) real income and smaller changes in (Y). - LM 9:16f Fiscal Since t in Policy> IS change (note: Expanslonary I is steep, G, tMd, ti. This policy FPISto Right) IS will also steep. IS shifts rightward to IS1. in interest rate would lead to a small changes (i), but is the most effective policy since it has a in real income Pg 1 L s LM Conclusion: FP large changes large in real income. (Y). 2/ Monetarist LM Curve is steep I S curve is flat Monetary Policy > LM change (note: Expansionary MP LM to Right) Ms 1, LM shifts rightward, i , real output . When MS t, Ms> Md, i l, cost of borrowing .I t,Y 1. Since the DD for real money balances is interest inelastic, the shift in LM Curve affects income more than i (Yi) This policy would lead to a small changes in i, but large changes in real income (Y). LM -IS Fiscal PolicyIS change (note: Expansionary FP > IS to Right) in G, Md, tl, TY. in G IS shifts rightward to IS Since I is interest elastic, the shift in the IS will have greater effect on i than on income (i>Y) This policy would lead to a large changes in i, but small changes in real income (Y) M Pa 16 IS Conclusion: MP is the most effective policy since it has a large 1 in real income. 9 KCrowding outin an ISLM model The ISLM can be used to illustrate a partial and a complete crowding out which were affected by the government deficit. If government deficit: meaning that the taxes collection is lesser than the government expenditure use expansionary FP 1/ Partial clo - Assumption: LM is steep. 2 IS Deficitthe government tries to finance the deficit either by increases the G or decreases the T. As G,IS >Rightif. Asi T1J ADJ. In fact, the government deficit is partly finance by a REDUCTION in the l, C, G, X (sebahagian tG ditampung oleh J(1/C/G/X). 2/ Complete clo - Assumption: LM is perfectly inelastic LM is vertical, means that the Md depends only on Y, but not on i. Pa: l63 5IS In this case, shift in the IS will lead to increase in i, but not in Y. TiMto offset completely the fG( G crowded out an equal amount of 1). Ti totalyJin I The government deficit is fullyfinance by a REDUCTION in the I, C, G, X (1G ditampung sepenuhnya oleh (VC/G/X)). Conclusion: 7The steeper the LM and the flatter the IS, the greater the magnitude of clo. 10 LCrowdingout effect under Keynes and Monetarist Lmflat a) Keynes IS stee 9 : 66 LM Yo b) MonetaristLm Ssteep Is flat LMM Conclusion: Keynesian theory is effective than Monetarist theory in order to solve the government deficit. 11