1. Chapter 24 Linking the Financial System and the Economy: The IS-LM-FE Model

2. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 24-2 A Model for Goods and Assets Markets: Assumptions General equilibrium occurs when all the markets are in simultaneous equilibrium. The goods market includes trade in all goods and services that the economy produces. The money market includes trade in all assets used as the medium of exchange. Nonmoney asset market includes trades of nonmonetary assets that are stores of value.

3. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 24-3 The IS Curve The goods market is in equilibrium when Y = C + I + G. When the goods market is in equilibrium, national saving equals national investment. The IS curve summarizes the equilibrium in the goods market.

4. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 24-4 Determinants of National Saving National saving increases when current income or current output rise. A rise in expected future income causes national saving to fall. National saving increases with the interest rate, although the effect probably isn’t large. Holding current output constant, an increase in government purchases reduces saving.

5. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 24-5 Determinants of National Investment An increase in expected future profitability of capital increases investment. An increase in the expected real interest rate lowers the demand for investment.

6. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 24-6 Figure 24.1 The IS Curve Graph

7. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 24-7 Figure 24.2 Excess Demand and Supply in the Goods Market

8. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 24-8 Table 24.1 Accounting for Shifts of the IS Curve

9. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 24-9 Determining Output: The Full Employment Line Full-employment output is the production level when all production factors are used. On the IS diagram, full employment is represented as a vertical line at Y *.

10. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 24-10 Table 24.2 Accounting for Shifts of the FE Line

11. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 24-11 The LM Curve In the asset market: M d + N d = M s + N s. Equilibrium in the nonmoney asset market implies equilibrium in the money market. The LM curve is the set of combinations of current output and the real interest rate for which the money market is in equilibrium.

12. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 24-12 Figure 24.4 The LM Curve Graph

13. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 24-13 Figure 24.5 Points Off the LM Curve

14. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 24-14 Table 24.3 Factors Shifting the LM Curve

15. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 24-15 The IS-LM-FE Model The financial and goods market are both in equilibrium when IS, FE, and LM intersect. The economy will restore equilibrium if the IS curve, the LM curve, or the FE line shifts. The neutrality of money implies that a one- time change in the nominal money supply affects only nominal variables.

16. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 24-16 Figure 24.7 Changing the Equilibrium

17. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 24-17 Figure 24.8 Price Level Adjustment to Restore Equilibrium