(Based on Macroeconomic Analysis: Edward Shapiro- Chap. 8,9,12 and Macroeconomics by N. G. Mankiw) Macroeconomics & The Global Economy -Term III Ace Institute

Macroeconomics & The Global Economy -Term IIIAce Institute of Management

Chapter 10: Keynesian Model and ISLM curves

(Based on Macroeconomic Analysis: Edward Shapiro- (Based on Macroeconomic Analysis: Edward Shapiro- Chap. 8,9,12 and Macroeconomics by N. G. Mankiw)Chap. 8,9,12 and Macroeconomics by N. G. Mankiw)

Instructor

Sandeep Basnyat

[email protected] Mobile: 9841 892281

mailto:[email protected]

Classical approach-a Classical approach-a reminderreminder Stable equilibrium in all sectors through market

mechanism The interaction between demand and supply forces in a

long run.

Even wage rate and prices moves both ways – upward and downward – adjusting with the change in demand and supply in an economy.

No economy would suffer from over production, as supply will automatically create its own demand.

No government intervention

Theories didn’t work with the Great Depression of 1930s

The great Depression The great Depression of 1930sof 1930s

Very High Production after WW1

Decrease in price of goods

and services Oversaw actual economic demand

Number of Industries suffered

Didn’t increase demand

High unemployment

Mass layoff

Huge Wage cut

UnderProduction /

GDP fell

Didn’t improve employment

Could not stimulate Demand

Big question- Why was economy sluggish?Big question- Why was economy sluggish?

Evolution of Keynesian Evolution of Keynesian Theory Theory

British Economist John Maynard Keynes British Economist John Maynard Keynes analyzed economic issues in a different analyzed economic issues in a different way through his world famous book – way through his world famous book – A A General Theory of Employment, Interest General Theory of Employment, Interest and Moneyand Money

Basic Concepts:Basic Concepts:Effective demand Effective demand Aggregate Demand and Aggregate Demand and Aggregate SupplyAggregate Supply

Keynesian MacroeconomicsKeynesian Macroeconomics His arguments were: His arguments were:

Due to the presence of strong labor union wage cut is not Due to the presence of strong labor union wage cut is not possible. Therefore possible. Therefore Wage is sticky downwards and flexible Wage is sticky downwards and flexible upwardsupwards

Economy, thus, does not operate at full employment levelEconomy, thus, does not operate at full employment level , , but at less than full employment level. but at less than full employment level.

The great Depression The great Depression of 1930sof 1930s

Very High Production after WW1

Decrease in price of goods

and services Oversaw actual economic demand

Number of Industries suffered

Didn’t increase demand

High unemployment

Mass layoff

Huge Wage cut

UnderProduction /

GDP fell

Didn’t improve employment

Could not stimulate Demand

Big question- Why was economy sluggish?Big question- Why was economy sluggish?

Keynesian MacroeconomicsKeynesian Macroeconomics His arguments were: His arguments were:

Due to the presence of strong labor union wage cut is not Due to the presence of strong labor union wage cut is not possible. Therefore Wage is sticky downwards and flexible possible. Therefore Wage is sticky downwards and flexible upwardsupwards

Economy, thus, does not operate at full employment level, but at Economy, thus, does not operate at full employment level, but at less than full employment level. less than full employment level.

Role of government is crucial because its policy decisions Role of government is crucial because its policy decisions can affect level of aggregate demandcan affect level of aggregate demand, which in turn affects , which in turn affects economic growth, employment and general price leveleconomic growth, employment and general price level

J.M. Keynes: Equilibrium in the EconomyJ.M. Keynes: Equilibrium in the Economy

For equilibrium, Planned Exp. = Actual Exp.

Planned Exp. Comes from Aggregate Demand (AD) where as Actual Exp. Comes from Aggregate Supply (AS) or National Income (Y)

Therefore, AD = Y or,

For Eg: Two sector equilibrium: C+I =Y

The equilibrium is known as Keynesian CrossThe equilibrium is known as Keynesian Cross

Case 1: Y > C + I -> (Actual investment > planned investment)

Case 2: C + I > Y -> (Actual investment < planned investment)

Note: Investment is an expenditure on expected demand

Components of Aggregate DemandComponents of Aggregate Demand

There are four types of demands in an economy Consumption Demand (C) Investment Demand (I) Demand for Government Expenditure (G) Demand for Foreign Trade (X-M)

Reminder,. Y = C +S where,

C = f (Yd) and S = f (Yd)

Marginal Propensity to Consume (mpc): The portion of any increase in disposable income that goes towards consumer spending.

Marginal Propensity to Save (mps): The portion of any increase in disposable income that is saved.

Consumption Consumption Demand (C)Demand (C)

Change in Consumption Expenditure Change in Disposable Income

= ∆C / ∆Yd

Change in Savings Change in Disposable Income

= ∆S / ∆Yd

mpc =

mps =

If, mpc + mps = 1, then mpc = 1- mps;

Consumption function and equationConsumption function and equation Mathematically, C = Ca + bY….consumption equation

Consumption demand has two components - autonomous consumption and induced consumption that is dependant on income and mpc.

Autonomous consumption are those spent mostly on sustenance and are independent of level of income.

Induced consumption depends on the level of income, mostly on comfort and luxurious goods Ca is the autonomous consumption, b is mpc and Y is the

total income (or total output of the economy).

Consumption Demand (continued ….)Consumption Demand (continued ….)

With the help of consumption equation we can construct With the help of consumption equation we can construct hypothetical income-consumption schedulehypothetical income-consumption schedule

Let CLet Caa=50, b = 0.75). Using=50, b = 0.75). Using, , C = Ca + bY

Income (Y)Income (Y) Consumption (C) Consumption (C) 00 5050100100 125125200200 200200300300 275275400400 350350

Y

C

Consumption demand

The functional relationship between Income and Consumption demand is the consumption function as drawn before.

Consumption FunctionConsumption Function Y - C = SAGGREGATE

INCOME(Billions of

Dollars)

AGGREGATE CONSUMPTION

(Billions of Dollars)

AGGREGATE SAVING

(Billions of Dollars)

0 100 -100

80 160 -80

100 175 -75

200 250 -50

400 400 0

600 550 50

800 700 100

1,000 850 150

Investment Demand (I)Investment Demand (I)

Spending by businesses on capital goods—factories, machinery, and other aids to production.

2 influences on the economy: Helps determine the economy’s level of total output and total

employment Critical determinant of the economy’s rate of growth as it

enlarges the economy’s stock of capital goods and thereby helps increase the economy’s capacity to produce goods and services

There are 3 forms of investment. Business Fixed Investment Residential Fixed Investment and Inventory Investment.

Investment Demand contd..Investment Demand contd..

Mathematically, I = Ia + eY e is the marginal propensity to invest and Ia is the autonomous

investment

As similar to consumption demand, investment demand can also be autonomous and/or induced

Autonomous investment are carried out to maintain the basic growth requirement. This is independent of level of income.

Induced investment depends on income level

Equilibrium Aggregate Output Equilibrium Aggregate Output (Income)(Income)

(All Figures in Billions of Dollars)

(1) (2) (3) (4) (5) (6)

AGGREGATEOUTPUT

(INCOME) (Y)

AGGREGATECONSUMPTION (C= 100+.75Y)

PLANNEDINVESTMENT (I)

PLANNEDAGGREGATE

EXPENDITURE (AE)C + I

UNPLANNED

INVENTORYCHANGEY (C + I)

EQUILIBRIUM?(Y = AE?)

100 175 25 200 100 No

200 250 25 275 75 No

400 400 25 425 25 No

500 475 25 500 0 Yes

600 550 25 575 + 25 No

800 700 25 725 + 75 No

1,000 850 25 875 + 125 No

Effect of Change in spendingEffect of Change in spending

I

Y

C+I

C+I+I

Y=ADAD, C, I

Y

E1

Y1

E

Y Y2

Y > I

Note: Small changes in spending are magnified into larger changes in income and output—the multiplier effect.

Initial equilibrium

Final equilibrium

The MultiplierThe Multiplier The ratio of change in total output to the change in total spending.

YIMathematically,

When initial earning of Rs. 10,000 produces total output of Rs. 50,000, the multiplier is 5 . Assume that mpc is .80, i.e., people spend 80% of the earnings. Initial earning of Rs. 10,000 incur initial spending of Rs. 8000 Since this Rs. 8000 is earning for someone else, the overall economy’s

output increases by Rs. 8000. Now, Rs. 8000 incur further spending of Rs. 6400 as mpc = 0.8 Now the economy’s total output is 10000+8000+6400+…= 50,000.

Multiplier depends on the value of marginal propensity to consume

(b) .

The The MultiplierMultiplier

How much is the How much is the multiplier here?multiplier here?

The Multiplier Equation-Two SectorsThe Multiplier Equation-Two Sectors

Households and Business firms only.

Assume a small increase in overall income of an economy Increase in income will form a part of consumption and investment.

Y = C + I. Dividing both sides by Y, we get

Y C I

Y Y Yor,

C I1

Y Y== + + Y

or, I

= 1- YC

= -1 mpc

or, IY

=1 mpc-

1 IYSince is the Multiplier by definition,

Multiplier (k) =mpc-1

1=

1

1 b-Since, mps (s) = 1-b

Multiplier (k) = 1s =

1

b-1

Finding equilibrium in 2 sector economyFinding equilibrium in 2 sector economy

For equilibrium, Y = C+I

Let us assume that all investment is autonomous,

So, I = Ia (Remember I = Ia + eY)

Then, Y = Ca + bY + Ia

or Y – bY = Ca + Ia

or (1-b)Y = Ca + Ia

or Y = [1/(1-b)](Ca + Ia)

Hence, equilibrium output is [1/(1-b)] (Ca + Ia)

As, [1/(1-b)] is the multiplier and is denoted by k, equilibrium output will be Y = k (CY = k (Caa + I + Iaa))

Effect of Change in InvestmentEffect of Change in Investment

What happens if there is an increase in investment?

Let I be increased by I. This will subsequently increase the output by Y

New investment will be I +I and corresponding output will be Y +Y

Hence, Y+ Y = k (Ca + Ia+I)

or Y = k (Ca + Ia) + kI – Y = Y + kI – Y Y = k I

This shows that an increase in investment by I will increase the output by k I.

Basic Keynesian Model-3 sectors Basic Keynesian Model-3 sectors economyeconomy The aggregate demand of an economy will be total

demand created by three sectors namely, household, business and government.

Government spending (G): purchases of goods and services by government

Cases:

What happens to equilibrium when government uses its fiscal policies?

Note:

Increase in ‘G’ increases total output

Increase in Revenue through tax decreases total output

Works with Multiplier effect

Government In The Economy-Government In The Economy-EquilibriumEquilibrium

Fiscal Policy At Work: Multiplier Fiscal Policy At Work: Multiplier Effects: Effects: Case 1 – No tax modelCase 1 – No tax model

Y = AD = C + I + G

As stated earlier, C = Ca + bY,

For a simplest analysis of three-sector Keynesian Model we assume Investment demand as autonomous and Government Expenditures are constant. Thus, I = Ia and G is constant

Equation (iii) can now be written as

Y = Ca + bY + Ia + G

or Y-bY = Ca + Ia + G

or (1-b)Y = Ca + Ia+ G

or Y = 1/1-b(Ca + Ia+ G)

Here, value of simple multiplier in a three sector Economy is 1/1-b.

Fiscal Policy At Work: Multiplier Effects: Fiscal Policy At Work: Multiplier Effects: Case 1 – ‘G’ Increases (but No Tax) modelCase 1 – ‘G’ Increases (but No Tax) model

Multiplier Effects: Case 2 – Tax imposed Multiplier Effects: Case 2 – Tax imposed by the govt.by the govt.

When tax is imposed, the disposable income of a consumer decreases by Y-T.

C = Ca + bY= Ca + b(Y-T)

Assume, I = Ia and G is constant

Y = Ca + b(Y-T) + Ia + G

or Y – bY = Ca + Ia + G – bT

or (1-b)Y = Ca + Ia + G – bT

or Y = 1/1-b(Ca + Ia + G – bT)

Keynesian Economics-Four Sector Keynesian Economics-Four Sector (Open) Economy(Open) Economy

Export and Import are included in a four sector economy.

Exports depend on the income of foreigners and therefore it is exogenously determined in the home country.

Import on the other hand is a function of level of income.

Import is given by M = Ma + mY Ma = Autonomous Import and mY = Induced Import

Four Sector Economy- Case 1: Simple Four Sector Economy- Case 1: Simple Keynesian model including the external Keynesian model including the external sectorsector Y = AD = C + I + G + (X-M)

Where C = Ca + bY and M = Ma + mY

I is autonomous and G and X are exogenously determined

Now, putting these values in Y,

Y = Ca + bY + I + G + X – Ma – mY

or Y – bY + mY = Ca + I + G + X – Ma

or (1-b+m)Y = Ca + I + G + X – Ma

or Y = (1/1-b+m)(Ca + I + G + X – Ma)

So, Equilibrium Output:

Y = (1/1-b+m)(Ca + I + G + X – Ma)

Value of Multiplier: 1/1-b+m

Keyne’s explanation on-The Keyne’s explanation on-The Recessionary and Inflationary Recessionary and Inflationary

S = National Saving

I = National Investment

S – I = Saving investment gap

If S > I, National Surplus

Govt. can utilize the surplus if, G > T. How much,

G-T = Expenditure revenue gap

For an economy to be in equilibrium,

S – I = G-T

The Recessionary and Inflationary The Recessionary and Inflationary GapsGaps

(C + I)1 = economy’s total expenditure function and existing level of equilibrium GDP

(C + I)2 = full-employment output—the level of output that allows to achieve target rate of unemployment.

Recessionary Situation—a period of weak economic activity and relatively high unemployment.

Recessionary Gap =The amount by which the equilibrium GDP falls short of full-employment, or potential, GDP

Causes a recession? Keynes: too little spending. (G-T < S-I)

Solution: Increase level of planned expenditure (Remember 1930s case?)

(C+I)1

e

Y

Actual Equilibrium

Y1

(C+I)2

e1

Desired Equilibrium at Full Employment

Reduction in output

The Recessionary GapThe Recessionary Gap

Recessionary Gap

Two Gaps Model-Two Gaps Model-The Recessionary and The Recessionary and Inflationary GapsInflationary Gaps

(C + I)1 = economy’s planned expenditure function and existing level of equilibrium GDP

(C + I)2 = full-employment output—the level of output that allows to achieve target rate of unemployment.

If the economy is operating in full employment level, the economy cannot provide more than Y1 level of goods and services.

If consumers and investors attempt to purchase more output than the economy is capable of producing, higher prices result as prospective buyers bid against one another.

But Real GDP will not increase. Only money GDP

Inflationary Gap =The amount by which the equilibrium GDP exceeds full-employment, or potential, GDP (G-T > S-I)

Solution: Decrease level of planned expenditure.

(C+I)2e

Y

Actual Equilibrium

Y1

(C+I)1

e1

Desired Equilibrium at Full Employment

Increase in potential GDP

The Inflationary GapThe Inflationary Gap

Inflationary Gap

Paradox of thriftParadox of thrift

Where higher savings become disincentive in an economy when it leads to reduction in national output.

Shift of savings curve towards left results a shift in equilibrium point

Given an unchanged Investment curve, the shift in savings curve towards left decreases output subsequently from “Y” to “Y1”.

Thriftiness (increased desire to save) without support from other economic variables can have undesired consequences

S

I

Y

S1

Y1

One Big Question !How would the market be in

equilibrium?

• Develop Goods market and money market

• Check how goods market and money market interact to determine the level of output and the interest rate.

The Goods Market and the Money The Goods Market and the Money MarketMarket

Goods market: in which goods and services are exchanged Equilibrium level of price of a product is determined by the demand and the supply of the product

Money market : The market in which financial instruments are exchanged Equilibrium level of the interest rate is determined by the supply of money and the demand for money

In two sector economy, equilibrium level of goods market is given by Y = C + I (Keynes)

Similarly, We know, Y = C+S.

So, C + I = C + S or S = I

Therefore, in two sector economy, goods market is also in equilibrium if S = I (financial market)

The Goods Market EquilibriumThe Goods Market Equilibrium

How will the Goods Market be in equilibrium?How will the Goods Market be in equilibrium?

We know that,

Savings is the positive function of Income

S = f(Y)

Investment is the inverse function of rate of interest

I = f(r);

The Goods Market EquilibriumThe Goods Market Equilibrium

Goods Market DisequilibriumGoods Market Disequilibrium

Y

r

IS

E F. .7

.

60

Disequilibrium Point

.

S > I Y > C + I

S > I Y > C + I

G

I > S C + I > Y

8

100

Keyne’s 3 Determinants of Demand for money:

Transaction Demand

Precautionary Demand

Speculative Demand

1. Transaction Demand: The main reason that people hold money—to buy things. As the income level increases people want to spend more

money. So, Transaction Demand is the direct function of Income.

DT = f (Y)

Money Market EquilibriumMoney Market Equilibrium

MD = MS


Precautionary Demand for Money

People hold money to meet emergencies and unexpected contingencies

As in the case of transaction demand, it is some fraction of total income and is positively related with the changes in money income

DP = f (Y)

Note: In most of cases precautionary demand is combined with transaction demand.


Speculative Demand for Money Speculative demand for Money refers to demand for holding

certain amount of cash in reserve to make speculative gain out of purchase and sale of bonds and securities.

The amount people prefer to maintain idle cash balance for speculative purpose depends on the rate of interest in the economy

There is an inverse relationship between speculative demand for money and rate of interest

DSP = f (r)Now Total Money Demand, MD = DT + DSP

Supply of Money

Money Supply is exogenously determined – that is from outside this model

The central monetary authority fixes the level of nominal stock of money supply.

For equality in money market, Money Demand must be equal to Money supply

MD = MS


Now Total Money Supply, Ms = DT + DSP

Since, Total Money Demand, MD = DT + DSP

If the interest rate is initially high enough to create an excess supply of money, the interest rate will immediately fall, discouraging people from moving out of money and into bonds.

If the interest rate is initially low enough to create an excess demand for money, the interest rate will immediately rise, discouraging people from moving out of bondsand into money.

Money Market Equilibrium-Liquidity Money Market Equilibrium-Liquidity Preference TheoryPreference TheoryThe money market is in equilibrium when Md = Ms

The equilibrium interest rate is the point at which the quantity of money supplied equals the quantity of money demanded.


DT

DSP

Y

r

DT

Y

DSP

r

MS = DT + DSP

DSP = f (r)

DT = f (Y)

LM curve

Speculative DemandMoney Market Equilibrium

Money SupplyTransaction Demand

6

$60Total Ms =$100

Assume Total Ms =$100

$40

$120

$120

6

Ms = Md

5

$50

$60

$50$50

$100

5

$100

An LM curve illustrates the positive relationship between the equilibrium value of the interest rate and aggregate output (income) (Y) in the money market.

High level of income calls for relatively large transaction balances, which, with a given supply of money can be drawn out of speculative balances only by pushing up the interest rates.

Y

r

LM

F

E

Money Market DisequilibriumMoney Market Disequilibrium

Ms > MdMd > Ms

4

5

6

100 120

For any combination located in the space to the right of the LM curve, there is a disequilibrium in which Md > Ms.

For any combination located in the space to the left of the LM curve, there is a disequilibrium in which Ms > Md.

Two Market Equilibrium-The Goods Two Market Equilibrium-The Goods and Money Marketsand Money Markets

Y

r

IS

LM

Ye

re

Two Market Equilibrium and Two Market Equilibrium and DisequilibriumDisequilibrium

Y

r

IS

LM

Ye

re S>I and MD>MS

S>I and MD<MS

I>S and MD<MS

I>S and MD>MS

A numerical example. Consider the economy of Nepal.

The consumption function is given by C = 250+0.75(Y-T). The investment function is I = 200-25r, where r is the interest rate. Government purchases and taxes are both 100. For this economy, find the IS equation.

The money demand function in Nepal is (M/P)d = Y -100r. The money supply Ms is 1,000 and the price level is 2. For this economy, find the LM equation.

Find the equilibrium interest rate and the equilibrium level of income. Assume that r =1 is equal to r =1%.

Suppose that the government purchases are raised from 100 to 150. How much does the IS curve shift? What are the new equilibrium interest rate and level of income?

With the initial values of monetary and fiscal policies, What are the new equilibrium interest rate and level of income when:

a) money supply doubles in the economy

b) price level rises from 2 to 4. What happens?


Solution:

Consumption: C = 250 + 0.75(Y − T)

Investment: I = 200 − 25r

Balanced budget: T = G = 100

IS equation?

We know in three sector economy, the IS equation is

Y = C + I + G.

A numerical exampleA numerical example


Solution:

Now substituting the value of C, I and G.

Y = 250 + 0.75(Y −T )+ 200 − 25r +100

or, Y = 250 + 0.75Y – 0.75T + 200 – 25r + 100

or, Y – 0.75Y = 550 – 0.75x100 - 25r

or, 0.25Y = 550 – 75 - 25r = 475 - 25r

or, Y = 1900 – 100r …………………(i)Y = 1900 – 100r …………………(i)










b) Solution:

The money demand function (M/P)d = Y -100r.

Money Supply (Ms) = 1000 and

Price Level (P) = 2

LM equation?

Money market equilibrium, Ms = Md

Substituting the value of Ms and Md,

1000 = Y −100r

Or,Y = 1000 + 100r Y = 1000 + 100r or …………..(2)…………..(2)

or, r = - 10 + 0.01Yr = - 10 + 0.01Y










Here,

IS Equation: Y = 1900 – 100r IS Equation: Y = 1900 – 100r and and

LM Equation: Y = 1000 + 100rLM Equation: Y = 1000 + 100r

Solving IS-LM Equation,

Therefore, Y = 1450Y = 1450

Substituting the value of Y in r

r = - 10 + 0.01Y = -10 + 0.01 x 1450 = -10 + 14.5 = 4.5

Therefore, r = 4.5%r = 4.5%










d) Given, Government purchases (G) raised

From 100 to 150. (no more balanced budget !)

Our original equation,

Y = C + I + G

Y = 250 + 0.75(Y − T) + 200 − 25r +150

Y -0.75 Y = 600 – 0.75T – 25r

0.25Y = 600 – 0.75 x 100 – 25r

0.25Y = 600 – 75 – 25r = 525 – 25r

Y = (525 – 25r) / 0.25 = 2100 – 100r


Therefore new IS equation is

Y = 2100 – 100rY = 2100 – 100r

LM curve remains the same:

Y = 1000 + 100rY = 1000 + 100r

Solving above equations,

Therefore, Y = 1550Y = 1550

Substituting the value of Y in above equation

1550 = 2100 – 100r => r = (1550 – 2100) / -100

r = -550 / -100 = 5.5

Therefore, r = 5.5%r = 5.5%


Conclusion: When Aggregate demand increases (increase in C, I or G), interest rate increases and Total Output (Y) increases.









b) Given,


Since Ms doubles Ms = 2000

Now New LM curve is,

2000 = Y -100r. New LM Equation is,

Y = 2000 + 100r

Solving new LM and old IS curve

r = 0.5%

Y = 2050

A numerical example-Ms doublesA numerical example-Ms doubles

Conclusion: When Money Supply increases, interest rate decreases and Total Output (Y) increases.

b) Given,


Since (M/P) = Ms,

Any increase in “M” increases Ms and any increase in “P” decreases Ms.

When P = 2, Ms = 1000

So, when, P = 4, Ms = 500

Now, original equation becomes,

500 = Y -100r =>

New LM Equation is

Y = 500 + 100r or, r = -5 + 0.01Y

A numerical example-P increases A numerical example-P increases from 2 to 4from 2 to 4

Original IS equation remains the same:

Y = 1900 -100r

Solving original IS equation and New LM equation:

Therefore, Y = 1200

Substituting value of Y in r equation, r = -5 + 0.01 x 1200 = 7%

Therefore r = 7%

A numerical example-P increases A numerical example-P increases from 2 to 4from 2 to 4

A numerical example-A numerical example-Price Level changes-graphical presentationPrice Level changes-graphical presentation

LM

IS

4.5%

7%

14501200

r

Y

LM1

How do government policies affect the market?

Monetary policy

Fiscal Policy

IS and LM and Monetary-Fiscal Policies

Y

r

Keynesian Range

Intermediate Range

Classical Range

LM Curve

r1

r2

r3

r4

r5

Different policies have different effects on different ranges

Use of Fiscal and Monetary Policies

r1

Assume Very Low-Close to Zero

IS1

LM1 LM2r

YY1

IS2

Y2

Liquidity Trap- Central Bank’s liquidity can not increase further output

Keynesian Range- as observed by Keynes

Liquidity Trap- a situation when the nominal interest rate is close or equal to zero and the monetary authority is unable to stimulate the economy with traditional monetary policy tools (failure of monetary policy).

People do not expect high returns on physical or financial investments, so they keep assets in cash bank accounts.

Keynesian Range-Liquidity Trap Keynesian Range-Liquidity Trap SituationSituation

Use of Fiscal and Monetary Policies

r1

Assume Very High

IS1LM1 LM2r

YY1

IS2

Y2

Classical Range- as observed by classical theorists

Monetary and Fiscal Policy-The Monetary and Fiscal Policy-The Intermediate Range-Shift in Intermediate Range-Shift in ISIS curve curve

r1

LMr

Y2

IS2

Y3

IS’2

The more closer is the equilibrium towards Keynesian range, more effective the fiscal policy is.

r2

r3

Monetary and Fiscal Policy-The Intermediate Monetary and Fiscal Policy-The Intermediate Range-Shift in Range-Shift in LMLM curve. curve.

r1

LM1 LM2

r

Y

IS

Y1

The more closer is the equilibrium towards classical range, more effective the monetary policy is.

r2

Y2

Range

Policy

Keynesian Range

Intermediate Range

Classical Range

Fiscal Policy

Most Effective Effective Ineffective

Monetary Policy Ineffective Effective

Most Effective

Effectiveness of Monetary and Effectiveness of Monetary and Fiscal Policies-General Fiscal Policies-General ConclusionConclusion

Try it !

Money Demand: Md = Y (0.2-i) where i is the rate of interest and Y is the income. Nominal Income Y = 2000 and Money Supply (Ms) = 300 Find Md for i = 10 % (or 0.1) and i = 5 % (or

0.05) What is the relation between i and Y Graph Ms and Md and Calculate the

equilibrium i. Central bank increases the Money Supply by

50. What happens to money market equilibrium? (solve and graph)

Try it !

Find the simultaneous equilibrium for the goods and money market when C = 100 + 0.80Yd; I = 150 – 6i; T = 0.25Y; G = 100; Md = 0.2 Y-2i and Ms = 150.

Calculate equilibrium rate of interest and output if C = 100 + 0.8Y, I = 150 - 6i, M = 150 and L = 0.20Y – 4i

Thank You

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Documents

(Based on Macroeconomic Analysis: Edward Shapiro- Chap. 8,9,12 and Macroeconomics by N. G. Mankiw) Macroeconomics & The Global Economy -Term III Ace Institute