Goods and Financial Markets1: IS-LM

1
Goods and Financial Markets1 IS-LM

• Goal link the goods and the financial markets
  into a more general model that will determine the
  equilibrium Y and the equilibrium i in the
  economy in the short run (with fixed prices)
• The goods market will be represented by the IS
  curve (standing for investment-savings)
• The financial markets (money market) will be
  represented by the LM curve (liquidity-money)
• 1. The Hicks-Hansen model based on Keynes
  General Theory

2
The goods market - IS curve

• Equilibrium condition Y Z ? C I G
• Investment will provide the link to the financial
  markets
• Determinants of investment
• If sales increase, producers might want to
  increase their productive capacity Y
• If the rate of interest rate i increases,
  producers find that borrowing to add new capital
  becomes more expensive

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• Equilibrium in the goods market becomes
• Y C(Y-T)I(Y,i) G
• Basically
• When i I and Ye
• When i I and Ye
• The ZZ curve shifts as the interest rate changes
  and a multiplier effect takes place
• If MPI is the marginal propensity to invest out
  of new income, assume that MPC MPI lt 1
• The slope of the ZZ curve is MPC MPI and the
  interest rate is included in the intercept

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Construction of the IS curve
YZ
ZZ(i)
Z
When the interest rate increases, I (Y, i)
drops and the ZZ curve shifts down. The economy
contracts from Ye to Ye. E and E correspond
to 2 combinations of i and Y, such that the good
market is in equilibrium.
ZZ(i)
i
Y
Ye
Ye
i
E
i
E
i
IS
Y
Ye
Ye
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The IS curve

• Y C(Y-T)I(Y, i) G
• Definition All the combinations of i and Y such
  that the goods market is in equilibrium i.e. the
  above equation is satisfied
• Shift of the IS A change in any of the
  exogenous variables in the equation will cause IS
  to shift.
• Shift variables
• c0 and I0 (confidence variables)
• T and G (policy - fiscal - variables)

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Expansionary fiscal policy increase in G
YZ
ZZ(G?G)
Z
ZZ (G)
When G increases, ZZ shifts up and IS shifts to
the right. An increase in T would has the
opposite effect as it is contractionary.
?G
Y
Ye
Ye
i
E
E
i
IS
IS
Y
Ye
Ye
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Shifts of IS
i
G T c0 I0
G T c0 I0
IS
Y
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The financial markets - LM curve

• Equilibrium condition1
• supply of money demand for money
• Ms PYL(i) or Ms/P YL(i)
• (Ms/P is the real money supply)
• It is clear that both LM and IS are relations
  between i and Y
• 1. The bonds market is automatically in
  equilibrium when the money market is in
  equilibrium

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Construction of the LM curve
Ms
i
i
LM
E
i1
i0
Md(Y1gtY0)
E
Md(Y0)
M/P
Y0 Y1
Y
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The LM curve

• Ms PYL(i)
• Definition All the combinations of i and Y such
  that the financial markets (bonds and money) are
  in equilibrium
• Shift of the LM curve a change in the money
  supply or a change in price or an exogenous shift
  in the money demand
• An increase in the money supply ( or a decrease
  in price) is expansionary
• A change in the velocity of money

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Expansionary monetary policy an increase in Ms
Ms
Ms
i
LM
i
LM
A
i0
i1
A
Md(Y0)
M/P
Y0 Y1
Y
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Shifts of LM
Contractionary
i
LM
Ms P V
Ms P V
Expansionary
Y