Introduction to the IS-LM curve and the General Equilibrium
Introduction to the IS-LMcurve and the GeneralEquilibrium
Review And Learning Objectives In this lecture we will present the complete IS/LM model. We will see how IS/LM can be used to explain the business cycle, and how it can answer fundamental questions about the effectiveness of fiscal and monetary policy. We will also briefly review how monetary and fiscal policy impacts the general equilibrium level. 2
Explaining Economic Fluctuations The intersection of the IS curve and the LM curve determines the level of national income. ◦ When one of these curves shifts, the short-run equilibrium of the economy changes, and national income fluctuates. We will examine how changes in policy and shocks to the economy can cause these curves to shift. We first consider what is the IS curve and what is the LM curve.
The IS Curve: Equilibrium in the Goods Market The goods market is defined as the aggregate market for goods and services. For any level of output ‘Y’, the IS curve also known as the ‘Investment Savings’ curve shows the interest rate ‘r’ for which the goods market is in equilibrium. Equilibrium in the market for goods and services occurs when the aggregate demand for goods and services, defined as , AD = Cd + Id + G0, is equal to the aggregate supply of goods and services (real GDP), Y. In other words, the goods market equilibrium condition is: Y =Cd + Id + G0.
The IS Curve: Equilibrium in the Goods Market We may also express this goods market equilibrium in terms of desired national saving and desired investment. By rearranging the A.S. = A.D. we get: Y - Cd - G0 = Id. Using the fact that national saving is defined as Sd = Y - Cd - G0. we get the equivalent equilibrium condition: Sd = Id Therefore, we have an equilibrium in the market for goods and services if desired national saving is equal to desired investment expenditure.
The IS Curve: Equilibrium in the Goods Market (cont)B) Derivation of the IS curve from the saving-investment diagram
THE MONEY MARKET & THE L.M. CURVEWhat is the Money Market?Is the segment of the financial market in which high liquidityassets are traded. (P.I.B. Pakistan Investment Bonds)(Forex Exchange rate and currency exchange)The LM curve (which stands for liquidity and money) plotsthe relationship between the interest rate and the level ofincome that arises in the money market.
Demand & Supply of Money d• Money Demand (M/P) Depends On: Income (Y) Interest Rates (I) (M/P)d = f(i,Y) s• Real Money Supply (M/P) : We assume Ms (Money Supply) is fixed by the central Bank
Building the LM curve The LM curve maps the relationship between r and Y for the money market equilibrium. Given money supply and The LM curve maps money demand suppose out this relationship an increase in income between raises money demand. r and Y. r r (M/P)s LMr2 r2r1 r1 L(r,Y1) L(r,Y2) Real Y Money Y1 Y2 Balances
Note that the realIS-LM and monetary sectors of the economy are in equilibrium r together. LM The intersection of the IS curve and the LM curve r* determines the level of national income. IS Y* Y
The Big PictureGoods ISMarket eq. curve IS-LM model ExplanationMoney LM of short-runMarket eq. curve fluctuations Agg. demand curve Model of Agg. Demand Agg. and Agg. supply Supply curve