IS curve

IS Curve ► Goods market equilibrium is derived using IS curve ► The IS curve (schedule) shows combinations of interest rates and levels of output such that planned spending equals income

Investment ► Some facts:  Investment is the principal link between the present and future  Between money market and goods market  Volatility in investment is considered responsible for fluctuations in GDP  Investment spending is affected by interest rate (monetary policy) and tax policies (fiscal policy)

Determinants of Investment ► Marginal product (efficiency) of capital (mec) is the increase in output produced by using 1 more unit of capital in the production ► The renter (user) cost of capital is the cost of using 1 more unit of capital in production (rate of interest, i) ► Real cost of borrowing is expected rate of interest minus expected inflation rate ► Cost also includes depreciation ► Thus, rc = r + d = i-n^ + d

Determinants of Investment.. ► Diminishing mec means marginal product drops as capital is increased ► Firms desire to add capital until the marginal return to the last unit added drops to the rental cost of capital (desired capital stock) ► That is, for firms to undertake investment, mec ≥ rc ► The general relationship among the desired capital stock, K*, the rc and the level of output is given by K* = g(rc, Y)

Investment and Interest rate ► So far, investment spending (I) was treated as entirely an exogenous variable ► But some component of I also depends upon interest rate ► Using these ideas, investment function for our AD framework can be defined as ► Where ‘i is the interest rate and coefficient b measures responsiveness of I to the interest rate

Interest rate and AD: IS curve

IS Curve ► Goods market equilibrium is derived using IS curve ► The IS curve (schedule) shows combinations of interest rates and levels of output such that planned spending equals income

LM curve

Money Market Equilibrium ► LM curve is the money market equilibrium schedule ► It shows combinations of interest rates and levels of output such that money demand equals money supply ► First, money demand is set L = f(Y,r) ► Second, we equate money demand with money supply ► Then, LM curve can be derived

Demand for money ► Demand for money is a demand for real balances M/P  People hold money for its purchasing power, for the amount of goods they can buy with it  Therefore real money demand is unchanged when price level increases; or nominal money demand increases in proportion to the increase in the price level

Factors influencing demand for money? ► Transactions motive – for making regular payment ► Precautionary motive – to meet unforeseen contingencies ► Speculative motive – uncertainties about the money value of other assets  There is a trade off between the benefits of holding more money verses the interest costs of doing so  Interest rate on money is referred to as the own rate of interest and the opportunity cost of holding money is equal to the difference between the yield on other assets and the own rate

More on Demand for Money ► Demand for real money balances responds negatively to the rate of interest ► Demand for money increases with the level of real income ► Short-run responsiveness of money demand to changes in interest rates and income is considerably less than long run responses

Demand for money ► That is, L = f (Y,r) L is positively related to Y, negatively related to r negatively related to r That is, L can be expressed as L = kY – hi; k,h > 0 parameters k and h reflect sensitivity of demand for money to the level of income and interest rate parameters k and h reflect sensitivity of demand for money to the level of income and interest rate