Chapter 4 Money, Interest, and Income

The goods market and the IS curve

Goods market equilibrium:

Investment and the interest rate:Relaxing the assumption of exogenously

determined investment spending;The linkage between investment and interest rate:

Firms borrow to purchase investment goods; Higher interest rate discourages investment.

0 1 (1 ) 1 (1 )

A C cTR I GY

c t c t

The goods market and the IS curve

The investment demand schedule:

0I I bi b

The goods market and the IS curve

The interest rate and aggregate demand: The IS curve

(1 )

AD C I G

cTR c t Y I bi G

A cY bi

Y AD A cY bi

1

A biY

c

The goods market and the IS curve

Derivation of the IS curve.

The goods market and the IS curve

The slope of the IS curve. Larger b implies flatter

IS curve; Larger multiplier

implies flatter IS curve.

The goods market and the IS curve

The position of the IS curve. Higher autonomous

spending shifts the IS curve to the right;

The horizontal shift equals the multiplier times the increase in autonomous spending.

The goods market and the IS curve

Positions off the IS curve: E3 v.s. E1:

Same income but lower interest rate;

Excess demand for goods.

E4 v.s. E2: Same income but higher

interest rate; Excess supply of goods.

The assets market and the LM curve Two types of assets:

Bonds: interest bearing;Money: no interest bearing.

The wealth constraint:An individual has to allocate his financial wealth

between bonds and money. Real and nominal money:

Nominal money: the dollar value;Real money: nominal money divided by the price

level.

The assets market and the LM curve

The demand side:

The accounting identity:

The assets market equilibrium:

The bond market is equilibrated whenever the money market is.

WNL DB

P

M WNSB

P P

( ) 0M

L DB SBP

The assets market and the LM curve The demand for money:

Households demand real balances instead of nominal money;

Why or why not hold money? Benefit: convenience; Cost: interest.

Determinants of real money demand: Real income: higher income implies more expenditure

hence more exchange needs; Interest rate: higher interest rate implies greater cost.

, 0L kY hi k h

The assets market and the LM curve

Demand for money.

The assets market and the LM curve

The supply of money, money market equilibrium, and the LM curve:The nominal quantity of money is set by the

Federal Reserve;Assuming for now that the price level is fixed;Money market equilibrium:

MkY hi

P

The assets market and the LM curve

Derivation of the LM curve.

The assets market and the LM curve

The slope of the LM curve:Larger k: steeper LM curve;Larger h: flatter LM curve.

The position of the LM curve:Increase real money supply and the LM curve

shifts outward.

The assets market and the LM curve An increase in money supply shifts the LM curve to

the right.

The assets market and the LM curve Positions off the LM curve:

E4 v.s. E1: larger income and excess demand for money;

E3 v.s. E2: lower income and excess supply of money.

Equilibrium in the goods and assets markets The intersection of the IS and LM curves represents

equilibrium on the goods and assets markets.

Equilibrium in the goods and assets markets Effects of an increase in autonomous spending on

income and the interest rate.

Adjustment toward equilibrium Assumptions:

Output increases whenever there is excess demand for goods and declines whenever there is excess supply of goods;

The interest rate rises whenever there is excess demand for money and falls whenever there is excess supply of money;

The speed of convergence is constant in both markets.

Adjustment toward equilibrium The assets market adjusts quickly.

Adjustment toward equilibrium The goods market adjusts quickly.

Adjustment toward equilibrium The speeds of convergence are comparable.

A formal treatment of the IS-LM model IS schedule:

LM schedule:

The equilibrium solution:

( )GY A bi

1 Mi kY

h P

0 0

1

G

b M k MY A i A

h P h h kb P

1 /G

Gk b h

A formal treatment of the IS-LM model The fiscal policy multiplier:

The multiplier is smaller than G;

Higher income implies higher interest rate, crowding out private investment;

Fiscal policy is weak for large b and k, or small h.

0

1 /G

G

Y

G k b h

A formal treatment of the IS-LM model The monetary policy multiplier:

Monetary policy is strong with small h and k, or large b and G.

0

( / )

Y b

M P h