slide 1 Diploma Macro Paper 2 Monetary Macroeconomics Lecture 3 Aggregate demand: Investment and the IS-LM model Mark Hayes

slide 2 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 market KX and IS (Y, C, I) Money market (LM) (i, Y) IS-LM (i, Y, C, I) AD Labour market (P, Y) AS AD-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*, π e IS*-LM* (e, Y, C, NX) AD*

Goods market KX and IS (Y, C, I) Money market (LM) (i, Y) IS-LM (i, Y, C, I) AD Labour market (P, Y) AS AD-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, π e IS*-LM* (e, Y, C, NX) AD*

slide 5 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:

slide 6 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

slide 7 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

slide 8 The investment demand curve i I I (i)I (i) Spending on investment goods is a downward- sloping function of the interest rate

slide 9 The investment demand curve i I I ( i, e 2 ) I ( i, e 1 ) e 2 > e 1

slide 10 Y2Y2 Y1Y1 Y2Y2 Y1Y1 Deriving the IS curve i I Y E i Y E =C +I (i 1 )+G E =C +I (i 2 )+G i1i1 i2i2 E =Y IS I E Y

slide 11 Y2Y2 Y1Y1 Y2Y2 Y1Y1 Shifting the IS curve: G At any value of i, G E Y Y E i Y E =C +I (i 1 )+G 1 E =C +I (i 1 )+G 2 i1i1 E =Y IS 1 The horizontal distance of the IS shift equals IS 2 …so the IS curve shifts to the right. Y

slide 12 Shifting the IS curve: T Y2Y2 Y2Y2 At any value of i, T C E E =C 2 +I (i 1 )+G IS 2 The horizontal distance of the IS shift equals Y E i Y E =Y Y1Y1 Y1Y1 E =C 1 +I (i 1 )+G i1i1 IS 1 …so the IS curve shifts to the left. Y

slide 13 The short-run equilibrium: IS-LM Y i IS LM Equilibrium interest rate Equilibrium level of income

slide 14 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!

slide 15 Money supply The supply of real money balances is fixed: M/P real money balances

slide 16 The demand for money

slide 17 Money demand (holding Y constant) Demand for real money balances: M/P real money balances

slide 18 Equilibrium (holding Y constant) The interest rate adjusts to equate the supply and demand for money: M/P real money balances

slide 19 Central Bank can raise the interest rate M/P real money balances

slide 20 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:

slide 21 Deriving the LM curve M/P i L (i, Y1 )L (i, Y1 ) i1i1 i2i2 i Y Y1Y1 i1i1 L (i, Y2 )L (i, Y2 ) i2i2 Y2Y2 LM (a) The market for real money balances (b) The LM curve

slide 22 How M <0 shifts the LM curve M/P i L (i, Y1 )L (i, Y1 ) i1i1 i2i2 i Y Y1Y1 i1i1 i2i2 LM 1 (a) The market for real money balances (b) The LM curve LM 2

slide 23 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 Equilibrium interest rate Equilibrium level of income (IS) (LM)

slide 24 Y1Y1 Y2Y2 Deriving the AD curve Y i Y P IS LM(P 1 ) LM(P 2 ) AD P1P1 P2P2 Y2Y2 Y1Y1 i2i2 i1i1 Intuition for slope of AD curve: P (M/P ) LM shifts left i I Y

slide 25 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

slide 26 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