# Goods and Financial Markets1: IS-LM

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 BlCh5 1 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 + -

BlCh5 I = I(Y,i) 2 Equilibrium in the goods market becomes: Y = C(Y-T)+I(Y,i) + G Basically When i When i I I and Ye 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 < 1 The slope of the ZZ curve is MPC + MPI and the interest rate is included in the intercept BlCh5

3 Construction of the IS curve Y=Z Z ZZ(i) When the interest rate increases, I (Y, i) drops ZZ(i) and the ZZ curve shifts down. The economy contracts from Ye to Ye. i Ye i i Ye E E

i BlCh5 Y IS Y e Y e E and E correspond to 2 combinations of i and Y, such that the good market is in equilibrium. Y 4 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) BlCh5 5 Expansionary fiscal policy: increase in G Y=Z Z ZZ(G+G) ZZ (G) G Ye Y

Ye i E i E IS IS BlCh5 Ye Ye Y 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. 6 Shifts of IS i G T c0 I0 G T c0 I0 IS Y BlCh5 7 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 BlCh5 8 Construction of the LM curve Ms i i LM E i1 i0 BlCh5 Md(Y1>Y0) Md(Y0) M/P

E Y0 Y1 Y 9 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 BlCh5 10 Expansionary monetary policy: an

increase in Ms Ms Ms i i LM LM A i0 i1 Md(Y0) M/P BlCh5 A Y0 Y1 Y 11

Shifts of LM i o C M P V c a r t n n o ti y r a LM Ms P

V s Ex n a p n o i s y r a Y BlCh5 12

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