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Diploma Macro Paper 2

Monetary Macroeconomics

Lecture 3

Aggregate demand:

Investment and the IS-LM model

Mark Hayes

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Outline

Introduction

Map of the AD-AS model

This lecture, continue explaining the AD curve

Last time, Step 1: Equilibrium with variable income and consumption – the Keynesian Cross

Step 2: Equilibrium with variable income, consumption and investment – the IS-LM model

This lecture highly theoretical, we look at the data with the help of the model next time

Goods marketKX and IS

(Y, C, I)

Moneymarket (LM)

(i, Y)

IS-LM(i, Y, C, I)

AD

Labour market(P, Y)

ASAD-AS

(P, i, Y, C, I)

Phillips Curve(,u)

Foreign exchange market(NX, e)

AD*-AS(P, e, Y, C, NX)

Exogenous: M, G, T, i*, πe

IS*-LM*(e, Y, C, NX)

AD*

Goods marketKX and IS

(Y, C, I)

Moneymarket (LM)

(i, Y)

IS-LM(i, Y, C, I)

AD

Labour market(P, Y)

ASAD-AS

(P, i, Y, C, I)

Phillips Curve(,u)

Foreign exchange market(NX, e)

AD*-AS(P, e, Y, C, NX)

Exogenous: M, G, T, πe

IS*-LM*(e, Y, C, NX)

AD*

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The IS curve

Definition: a graph of all pairs of i and Y that result in goods market equilibrium

i.e. value of output Y = expected expenditure E

Expected consumption C is an increasing function of income Y, as in the Keynesian Cross

PLUS: Expected investment I is now a decreasing function of the money rate of interest i

The equation for the IS curve is:

 

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Money and real interest rates

Mankiw uses r to mean both nominal (money) and real interest rates. This confuses the Classical and Keynesian models.

In a monetary model, only the money rate (i) exists as a causal variable.

The real interest rate only exists in a corn model.

What does exist in a monetary model is the expected rate of inflation e. This is exogenous here.

Investment depends on i - e

For clarity always use i in a monetary model

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A note on curve shifting

A curve (or line) in a diagram is a relationship between two endogenous variables

Movement along the curve shows how one variable changes if the other does

We are mainly interested in comparing equilibrium positions, how the point of intersection moves

A change in an exogenous variable shifts a curve, which moves the equilibrium position

Movement along a curve only happens in disequilibrium and may not be realistic

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The investment demand curve

i

I

I (i)

Spending on investment goods is a downward-sloping function of the interest rate

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The investment demand curve

i

I

I (i, e2)

I (i, e1)

e2 > e1

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Y2Y1

Y2Y1

Deriving the IS curve

i I

Y

E

i

Y

E =C +I (i1 )+G

E =C +I (i2 )+G

i1

i2

E =Y

IS

I E

Y

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Y2Y1

Y2Y1

Shifting the IS curve: G

At any value of i, G E Y

Y

E

i

Y

E =C +I (i1 )+G1

E =C +I (i1 )+G2

i1

E =Y

IS1

The horizontal distance of the IS shift equals

IS2

…so the IS curve shifts to the right.

1

1 MPC

Y G Y

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Shifting the IS curve: T

Y2

Y2

At any value of i, T C E E =C2 +I (i1 )+G

IS2

The horizontal distance of the IS shift equals

Y

E

i

Y

E =Y

Y1

Y1

E =C1 +I (i1 )+G

i1

IS1

…so the IS curve shifts to the left.

MPC

1 MPCY T Y

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The short-run equilibrium: IS-LM

Y

i

IS

LM

Equilibriuminterestrate

Equilibriumlevel ofincome

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The money market

What determines the money interest rate?

NOT the supply and demand for loanable funds!

In the monetary model, the interest rate clears the money market, matching the supply and demand for a stock of money

In the Classical model, the interest rate clears the loanable funds market, matching the supply and demand for flows of saving for investment

Oil and water!

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Money supply

The supply of

real money balances is fixed: sM P M P

M/P real money

balances

 

sM P

M P

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The demand for money

 

 

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Money demand (holding Y constant)

Demand forreal money balances:

M/P real money

balances

 

sM P

M P

   

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Equilibrium (holding Y constant)

The interest rate adjusts to equate the supply and demand for money:

M/P real money

balances

 

sM P

M P

  

¿¿

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Central Bank can raise the interest rate

To increase , CB reduces M

M/P real money

balances

interestrate

1M

P

1

2

2M

P

 

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The LM curve

The LM curve is a graph of all

combinations of i and Y that equate the supply and demand for real money balances.

The equation for the LM curve is:

¿¿

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Deriving the LM curve

M/P

i

1M

P

L (i ,

Y1 )

i1

i2

i

YY1

i1L (i , Y2 )

i2

Y2

LM

(a) The market for real money balances (b) The LM curve

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How M <0 shifts the LM curve

M/P

i

1M

P

L (i , Y1 ) i1

i2

i

YY1

i1

i2

LM1

(a) The market for real money balances (b) The LM curve

2M

P

LM2

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The short-run equilibrium: IS-LM

The short-run equilibrium

is the combination of i and Y that simultaneously satisfies the equilibrium conditions in the goods & money markets:

Y

i

IS

LM

Equilibriuminterestrate

Equilibriumlevel ofincome

𝒀=𝒄𝟏(𝒀 −𝑻 )+𝑰 (𝒊 )+𝑮

¿¿(IS)

(LM)

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Y1Y2

Deriving the AD curve

Y

i

Y

P

IS

LM(P1)

LM(P2)

AD

P1

P2

Y2 Y1

i2i1

Intuition for slope of AD curve:

P (M/P )

LM shifts left

i

I

Y

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Summary

We have derived the AD curve as a set of pairs of P and Y consistent with simultaneous equilibrium in the goods and money markets

The building blocks of the AD curve are the Keynesian Cross and the IS-LM model

We now have four endogenous variables:

Y, C, I and i

Exogenous variables include P, M, G and T

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Next time

Applying the IS-LM model:– Fiscal policy

– Monetary policy

Revise this lecture and make sure you understand how the model works before the next lecture!

Especially: consider the meaning of different slopes of the IS and LM curves