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Y C (Y T ) I G
I I (Y ,i)
The Determination of
Output
Taking into account the investment
relation above, the equilibrium
condition in the goods market
becomes:
Y C (Y T ) I (Y ,i) G
The Determination of
Output
Equilibrium in the Goods
Market
The demand for goods is
an increasing function of
output. Equilibrium
requires that the demand
for goods be equal to
output.
The IS Curve
Shifts of the IS
Curve
An increase
in taxes...
Financial Markets
and the LM Relation
The interest rate is determined by
the equality of the supply of and
the demand for
M money:
$ Y L (i)
M = nominal money stock
$YL(i) = demand for money
$Y = nominal income
i = nominal interest rate
Y L (i)
Recall: before, we had the same equation but in nominal instead of real
terms (nominal income and nominal money supply). Dividing both
sides by P (the price level) gives us the equation above.
An
increase
in
money...
Equilibrium in the
goods market (IS).
Equilibrium in financial
markets (LM).
When the IS curve
intersects the LM
curve, both goods and
financial markets are
in equilibrium.
IS r e la tio n : Y C (Y T ) I (Y ,i ) G
L M r e la tio n :
M
Y L (i)
P
Monetary contraction
(tightening) refers to a
decrease in the money supply.
An increase in the money supply
is called monetary expansion.
Monetary policy affects only the
LM curve, not the IS curve.
Shift of
LM
Movement of
Output
Movement in
Interest Rate
Increase in taxes
left
none
down
down
Decrease in taxes
right
none
up
up
Increase in spending
right
none
up
up
Decrease in spending
left
none
down
down
Increase in money
none
down
up
down
Decrease in money
none
up
down
up
Crowding Out
Given Md = 0.25 + 62.5i; IS -----> Y = 4250 125i
and LM -------> Y = 2000 + 250i. Is there crowding out
if government spending increases 1500? How much?
IS0 ------> Y = 4250 125i
LM -----> Y = 2000 + 250i
IS1 ------> Y = 5750 125i
Initial equilibrium IS0 = LM at Y = 3500 and r 0 = 6%.
If government spending increases, then IS1 = LM at Y
= 4500 and r1 = 10%.
If interest rate is unchanged (6%), then after
government spending increases:
Y = 5750 125r
= 5750 125(6)
= 5000
So, crowding out is 5000 4500 = 500
r
IS1
LM0
IS0
10
3500
Y
4500 5000