relationship between money and goods markets
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Relationship between theRelationship between theMoney and Goods MarketsMoney and Goods Markets
Relationship between the Money and Goods MarketsRelationship between the Money and Goods Markets
Effects of Monetary Changes on
National Income
Effects of Monetary Changes on
National Income
MONEY AND NATIONAL INCOMEMONEY AND NATIONAL INCOME
• The quantity theory of money
– the quantity equation: MV = PY
– the stability of V
– the stability of Y
• Interest-rate transmission mechanism
– stage 1: money – interest rate link
– stage 2: interest rate – investment link
– stage 3: multiplier effect
• The quantity theory of money
– the quantity equation: MV = PY
– the stability of V
– the stability of Y
• Interest-rate transmission mechanism
– stage 1: money – interest rate link
– stage 2: interest rate – investment link
– stage 3: multiplier effect
r1
MS
L
Effect of a rise in money supply:the traditional Keynesian transmission mechanism
Effect of a rise in money supply:the traditional Keynesian transmission mechanism
O
Ra
te o
f in
tere
st
Money
I
O O
Ra
te o
f in
tere
st
Ra
te o
f in
tere
st
MS
L
r1
Money InvestmentI1
r1
Effect of a rise in money supply:the traditional Keynesian transmission mechanism
Effect of a rise in money supply:the traditional Keynesian transmission mechanism
Y1O
W
J1
(= I1 + G + X)
Effect of a rise in money supply:the traditional Keynesian transmission mechanism
Effect of a rise in money supply:the traditional Keynesian transmission mechanism
I2O O
Ra
te o
f in
tere
st
Ra
te o
f in
tere
st
MS
L
r1 r1
I
Money InvestmentI1
MS'
r2 r2
(b) Stage 2: r I (b) Stage 2: r I (a) Stage 1: MSr (a) Stage 1: MSr
Effect of a rise in money supply:the traditional Keynesian transmission mechanism
Effect of a rise in money supply:the traditional Keynesian transmission mechanism
O
W
J1
(= I1 + G + X)
Y1
J2
(= I2 + G + X)
Y2
(c) Stage 3: I J Y (c) Stage 3: I J Y
Effect of a rise in money supply:the traditional Keynesian transmission mechanism
Effect of a rise in money supply:the traditional Keynesian transmission mechanism
• Limitations of the interest rate transmission mechanism
– possible problems with stage 1: money – interest rate link
• elastic demand for money
• Limitations of the interest rate transmission mechanism
– possible problems with stage 1: money – interest rate link
• elastic demand for money
MONEY AND NATIONAL INCOMEMONEY AND NATIONAL INCOME
O
Ra
te o
f in
tere
st
Money
MS
Lr1
MS'
r2
MS"
An elastic liquidity preference curveAn elastic liquidity preference curve
• Limitations of the interest rate transmission mechanism
– possible problems with stage 1: money – interest rate link
• elastic demand for money
• unstable demand for money
• Limitations of the interest rate transmission mechanism
– possible problems with stage 1: money – interest rate link
• elastic demand for money
• unstable demand for money
MONEY AND NATIONAL INCOMEMONEY AND NATIONAL INCOME
O
Money
Ra
te o
f in
tere
st
MS
L
r
L '
r1
The effect on interest rates of a fluctuating demand for moneyThe effect on interest rates of a fluctuating demand for money
• Limitations of the interest rate transmission mechanism
– possible problems with stage 1: money – interest rate link
• elastic demand for money
• unstable demand for money
– possible problems with stage 2: interest rate – investment link
• Limitations of the interest rate transmission mechanism
– possible problems with stage 1: money – interest rate link
• elastic demand for money
• unstable demand for money
– possible problems with stage 2: interest rate – investment link
MONEY AND NATIONAL INCOMEMONEY AND NATIONAL INCOME
• Limitations of the interest rate transmission mechanism
– possible problems with stage 1: money – interest rate link
• elastic demand for money
• unstable demand for money
– possible problems with stage 2: interest rate – investment link
• inelastic investment demand
• Limitations of the interest rate transmission mechanism
– possible problems with stage 1: money – interest rate link
• elastic demand for money
• unstable demand for money
– possible problems with stage 2: interest rate – investment link
• inelastic investment demand
MONEY AND NATIONAL INCOMEMONEY AND NATIONAL INCOME
O
(a) Keynesian(a) Keynesian
Ra
te o
f in
tere
st
Investment
I
I1
r1
Different views on the demand for investmentDifferent views on the demand for investment
O O
(a) Keynesian(a) Keynesian (b) New classical / Monetarist(b) New classical / Monetarist
Ra
te o
f in
tere
st
Ra
te o
f in
tere
st
r1
Investment Investment
I
I
I1 I1
r1
Different views on the demand for investmentDifferent views on the demand for investment
O O
(a) Keynesian(a) Keynesian (b) New classical / Monetarist(b) New classical / Monetarist
r1
Ra
te o
f in
tere
st
Ra
te o
f in
tere
st
r1
Investment Investment
I
I
I1 I1
r2
I2
Different views on the demand for investmentDifferent views on the demand for investment
O O
(a) Keynesian(a) Keynesian (b) New classical / Monetarist(b) New classical / Monetarist
r1
Ra
te o
f in
tere
st
Ra
te o
f in
tere
st
r1
Investment Investment
I
I
I1 I1
r2 r2
I2 I2
Different views on the demand for investmentDifferent views on the demand for investment
• Limitations of the interest rate transmission mechanism
– possible problems with stage 1: money – interest rate link
• elastic demand for money
• unstable demand for money
– possible problems with stage 2: interest rate – investment link
• inelastic investment demand
• unstable investment demand
• Limitations of the interest rate transmission mechanism
– possible problems with stage 1: money – interest rate link
• elastic demand for money
• unstable demand for money
– possible problems with stage 2: interest rate – investment link
• inelastic investment demand
• unstable investment demand
MONEY AND NATIONAL INCOMEMONEY AND NATIONAL INCOME
O
I1
Q0
r0
Investment
Rat
e of
inte
rest
r1
Q1
The effects of interest rate changes, given an unstable investment demand curve
The effects of interest rate changes, given an unstable investment demand curve
O
I1
Q0
r0
Investment
Rat
e of
inte
rest
r1
Q1
I2
Q2
The fall in interest rates isaccompanied by an increase
in business confidence
The effects of interest rate changes, given an unstable investment demand curve
The effects of interest rate changes, given an unstable investment demand curve
O
I1
Q0
r0
Investment
Rat
e of
inte
rest
r1
Q1
The fall in interest rates isaccompanied by a decrease
in business confidence
I3
Q3
The effects of interest rate changes, given an unstable investment demand curve
The effects of interest rate changes, given an unstable investment demand curve
MONEY AND NATIONAL INCOMEMONEY AND NATIONAL INCOME
• The exchange-rate transmission mechanism
– the stages
• money supply – interest rate link
• interest rate – exchange rate link
• exchange rate – import and export link
• The exchange-rate transmission mechanism
– the stages
• money supply – interest rate link
• interest rate – exchange rate link
• exchange rate – import and export link
MS
L
O
Ra
te o
f in
tere
st
r1
Money
The exchange rate transmission mechanismThe exchange rate transmission mechanism
O
D1
S1
O
Ra
te o
f in
tere
st
Exc
ha
nge
ra
te
MS
L
r1
Quantity of sterling
er1
Money
The exchange rate transmission mechanismThe exchange rate transmission mechanism
O O
M
D1
Exports (X), Imports (M)
er1
S1
X
er1
Exc
ha
nge
ra
te
M1X1
Quantity of sterling
Exc
ha
nge
ra
te
The exchange rate transmission mechanismThe exchange rate transmission mechanism
W1 (= S + M1 + T)
J1 (= I + X1 + G)
O Y1
W, J
Y
The exchange rate transmission mechanismThe exchange rate transmission mechanism
O O
Ra
te o
f in
tere
st
Exc
ha
nge
ra
te
MS
L
r1
D1
Money Quantity of sterling
er1
S1MS'
r2
(a) Stage 1: MSr
The exchange rate transmission mechanismThe exchange rate transmission mechanism
O O
Ra
te o
f in
tere
st
MS
L
r1
D1
Money Quantity of sterling
er1
S1MS'
r2
(a) Stage 1: MSr (b) Stage 2: MSr er
D2
S2
er2
Exc
ha
nge
ra
te
The exchange rate transmission mechanismThe exchange rate transmission mechanism
O O
D1
Quantity of sterling
er1
S1
(b) Stage 2: MSr er
D2
S2
er2
Exc
ha
nge
ra
te
The exchange rate transmission mechanismThe exchange rate transmission mechanism
O
D1
Quantity of sterling
er1
S1
D2
S2
er2
(b) Stage 2: MSr er
O
M
X
Exports (X), Imports (M)
er1
Exc
ha
nge
ra
te
M1X1
(c) Stage 3: er M , X
er2
X2M2
Exc
ha
nge
ra
te
The exchange rate transmission mechanismThe exchange rate transmission mechanism
O Y1
(d) Stage 4: M , X Y
W1 (= S + M1 + T)
J1 (= I + X1 + G)
W2 (= S + M2 + T)
J2 (= I + X2 + G)
Y2
W, J
Y
The exchange rate transmission mechanismThe exchange rate transmission mechanism
MONEY AND NATIONAL INCOMEMONEY AND NATIONAL INCOME
• The exchange-rate transmission mechanism
– the stages
• money supply – interest rate link
• interest rate – exchange rate link
• exchange rate – import and export link
– the strength of the effect
• The exchange-rate transmission mechanism
– the stages
• money supply – interest rate link
• interest rate – exchange rate link
• exchange rate – import and export link
– the strength of the effect
MONEY AND NATIONAL INCOMEMONEY AND NATIONAL INCOME
• The exchange-rate transmission mechanism
– the stages
• money supply – interest rate link
• interest rate – exchange rate link
• exchange rate – import and export link
– the strength of the effect
– the variability of the effect
• The exchange-rate transmission mechanism
– the stages
• money supply – interest rate link
• interest rate – exchange rate link
• exchange rate – import and export link
– the strength of the effect
– the variability of the effect
• Portfolio balance
– the theory of portfolio balance
– Keynesian criticisms
– portfolio balance and the interest-rate mechanism
• The stability of the velocity of circulation
– short-run variability of V
– long-run stability of V
• Portfolio balance
– the theory of portfolio balance
– Keynesian criticisms
– portfolio balance and the interest-rate mechanism
• The stability of the velocity of circulation
– short-run variability of V
– long-run stability of V
MONEY AND NATIONAL INCOMEMONEY AND NATIONAL INCOME
M0 and M4 velocities of circulationM0 and M4 velocities of circulationM
0 ve
loci
tyM
4 velocity
M0 velocity
10
15
20
25
30
35
1970 1975 1980 1985 1990 1995 2000
0.80
1.00
1.20
1.40
1.60
1.80
2.00
2.20
2.40
M0 and M4 velocities of circulationM0 and M4 velocities of circulationM
0 ve
loci
ty
M0 velocity
M4 velocity
10
15
20
25
30
35
1970 1975 1980 1985 1990 1995 2000
0.80
1.00
1.20
1.40
1.60
1.80
2.00
2.20
2.40
M0 and M4 velocities of circulationM0 and M4 velocities of circulationM
0 ve
loci
ty
M4 velocity
M4 velocity
M0 velocity
10
15
20
25
30
35
1970 1975 1980 1985 1990 1995 2000
0.80
1.00
1.20
1.40
1.60
1.80
2.00
2.20
2.40
Relationship between the Money and Goods MarketsRelationship between the Money and Goods Markets
Monetary Effects of Changes in the Goods Market
Monetary Effects of Changes in the Goods Market
MONETARY EFFECTS OF GOODS MARKET CHANGESMONETARY EFFECTS OF GOODS MARKET CHANGES
• Monetary effects of changes in aggregate demand
– effect on interest rates
– effect on national income
• Monetary effects of changes in aggregate demand
– effect on interest rates
– effect on national income
O
W, J
Y
(a) The goods market(a) The goods market
W
J1
Y1
The monetary effects of a rise in injectionsThe monetary effects of a rise in injections
O O
W, JRate of interest
Y Money
(a) The goods market(a) The goods market (b) The money market(b) The money market
W
J1
Y1
MS
L1
r1
The monetary effects of a rise in injectionsThe monetary effects of a rise in injections
O O
W, JRate of interest
Y Money
(a) The goods market(a) The goods market (b) The money market(b) The money market
W
J1
Y1
MS
L1
r1
Y2
J2
An expansionaryfiscal policy
The monetary effects of a rise in injectionsThe monetary effects of a rise in injections
O O
W, JRate of interest
Y Money
(a) The goods market(a) The goods market (b) The money market(b) The money market
W
J1
Y1
MS
L1
r1
Y2
J2
An expansionaryfiscal policy
L2
r2
Effect on thedemand for money
The monetary effects of a rise in injectionsThe monetary effects of a rise in injections
O O
W, JRate of interest
Y Money
(a) The goods market(a) The goods market (b) The money market(b) The money market
W
J1
Y1
MS
L1
r1
Y2
J2
An expansionaryfiscal policy
L2
Accommodatingincrease in themoney supply
MS2
r2
The monetary effects of a rise in injectionsThe monetary effects of a rise in injections
MONETARY EFFECTS OF GOODS MARKET CHANGESMONETARY EFFECTS OF GOODS MARKET CHANGES
• Crowding out– the analysis of crowding out
– the extent of crowding out• responsiveness of demand for money to an
interest rate change
• responsiveness of investment to an interest rate change
– analysis under Keynesian and monetarist assumptions
• Crowding out– the analysis of crowding out
– the extent of crowding out• responsiveness of demand for money to an
interest rate change
• responsiveness of investment to an interest rate change
– analysis under Keynesian and monetarist assumptions
Different views on the demand for moneyDifferent views on the demand for money
O
MS
Lr1
Ra
te o
f in
tere
st
Money
(a) Keynesian(a) Keynesian
O O
MS
Lr1
Ra
te o
f in
tere
st
Ra
te o
f in
tere
st
MS
r1
L
Money Money
Different views on the demand for moneyDifferent views on the demand for money
(a) Keynesian (b) New classical / Monetarist(b) New classical / Monetarist
O O
MS
Lr1
Ra
te o
f in
tere
st
Ra
te o
f in
tere
st
MS
r1
L'r2
L
Money Money
Different views on the demand for moneyDifferent views on the demand for money
(a) Keynesian(a) Keynesian (b) New classical / Monetarist
O O
MS
Lr1
Ra
te o
f in
tere
st
Ra
te o
f in
tere
st
MS
L
r1
L'r2
r2
L'
Money Money
Different views on the demand for moneyDifferent views on the demand for money
(a) Keynesian (b) New classical / Monetarist(b) New classical / Monetarist
Different views on the demand for investmentDifferent views on the demand for investment
O
(a) Keynesian(a) Keynesian
Ra
te o
f in
tere
st
Investment
I
I1
r1
O O
(a) Keynesian (b) New classical / Monetarist(b) New classical / Monetarist
Ra
te o
f in
tere
st
Ra
te o
f in
tere
st
r1
Investment Investment
I
I
I1 I1
r1
Different views on the demand for investmentDifferent views on the demand for investment
O O
(a) Keynesian(a) Keynesian (b) New classical / Monetarist
r1
Ra
te o
f in
tere
st
Ra
te o
f in
tere
st
r1
Investment Investment
I
I
I1 I1
r2
I2
Different views on the demand for investmentDifferent views on the demand for investment
O O
(a) Keynesian (b) New classical / Monetarist(b) New classical / Monetarist
r1
Ra
te o
f in
tere
st
Ra
te o
f in
tere
st
r1
Investment Investment
I
I
I1 I1
r2 r2
I2 I2
Different views on the demand for investmentDifferent views on the demand for investment
MONETARY EFFECTS OF GOODS MARKET CHANGESMONETARY EFFECTS OF GOODS MARKET CHANGES
• Crowding out– the analysis of crowding out
– the extent of crowding out• responsiveness of demand for money to an
interest rate change
• responsiveness of investment to an interest rate change
– analysis under Keynesian and monetarist assumptions
• Money supply: exogenous or endogenous?
• Crowding out– the analysis of crowding out
– the extent of crowding out• responsiveness of demand for money to an
interest rate change
• responsiveness of investment to an interest rate change
– analysis under Keynesian and monetarist assumptions
• Money supply: exogenous or endogenous?
Relationship between the Money and Goods MarketsRelationship between the Money and Goods Markets
ISLM AnalysisISLM Analysis
ISLM ANALYSISISLM ANALYSIS
• The goods and money markets
• The IS curve– deriving the IS curve
• The goods and money markets
• The IS curve– deriving the IS curve
Inje
ctio
ns,
With
dra
wa
ls
OI1 (J1)
S1 (W1)R
ate
of i
nte
rest
O
r1
Goods market equilibrium: deriving the IS curveGoods market equilibrium: deriving the IS curve
Assume that an interestrate of r1 gives investment
of I1 and saving of S1
Inje
ctio
ns,
With
dra
wa
ls
OI1 (J1)
S1 (W1)
Assume that an interestrate of r1 gives investment
of I1 and saving of S1
Y1
Ra
te o
f in
tere
st
O
r1
Goods market equilibrium: deriving the IS curveGoods market equilibrium: deriving the IS curve
Inje
ctio
ns,
With
dra
wa
lsR
ate
of i
nte
rest
O
O
r1
I1 (J1)
S1 (W1)
Assume that an interestrate of r1 gives investment
of I1 and saving of S1
Y1
Y1
Goods market equilibrium: deriving the IS curveGoods market equilibrium: deriving the IS curve
Inje
ctio
ns,
With
dra
wa
lsR
ate
of i
nte
rest
O
O
r1
I1 (J1)
S1 (W1)
Assume that an interestrate of r1 gives investment
of I1 and saving of S1
Y1
Y1
a
Goods market equilibrium: deriving the IS curveGoods market equilibrium: deriving the IS curve
Inje
ctio
ns,
With
dra
wa
lsR
ate
of i
nte
rest
O
O
r1
I1 (J1)
S1 (W1)
Now assume that the interestrate falls to r2, giving
investment of I2 and saving of S2
Y1
Y1
I2 (J2)
S2 (W2)
Y2
r2
a
Goods market equilibrium: deriving the IS curveGoods market equilibrium: deriving the IS curve
Inje
ctio
ns,
With
dra
wa
lsR
ate
of i
nte
rest
O
O
r1
I1 (J1)
S1 (W1)
Now assume that the interestrate falls to r2, giving
investment of I2 and saving of S2
Y1
Y1
I2 (J2)
S2 (W2)
Y2
r2
a
Goods market equilibrium: deriving the IS curveGoods market equilibrium: deriving the IS curve
Inje
ctio
ns,
With
dra
wa
lsR
ate
of i
nte
rest
O
O
r1
I1 (J1)
S1 (W1)
Y1
Y1
I2 (J2)
S2 (W2)
Y2
r2
a
b
Now assume that the interestrate falls to r2, giving
investment of I2 and saving of S2
Goods market equilibrium: deriving the IS curveGoods market equilibrium: deriving the IS curve
Inje
ctio
ns,
With
dra
wa
lsR
ate
of i
nte
rest
O
O
r1
I1 (J1)
S1 (W1)
Now assume that the interestrate falls to r2, giving
investment of I2 and saving of S2
Y1
Y1
I2 (J2)
S2 (W2)
Y2
r2
IS(J = W)
b
a
Goods market equilibrium: deriving the IS curveGoods market equilibrium: deriving the IS curve
ISLM ANALYSISISLM ANALYSIS
• The goods and money markets
• The IS curve– deriving the IS curve
– elasticity of the IS curve
• The goods and money markets
• The IS curve– deriving the IS curve
– elasticity of the IS curve
The IS curveThe IS curve
Inje
ctio
ns,
With
dra
wa
lsR
ate
of i
nte
rest
O
O
r1
I1 (J1)
S1 (W1)
Y1
Y1
I2 (J2)
S2 (W2)
Y2
r2
IS(J = W)
b
a
ISLM ANALYSISISLM ANALYSIS
• The goods and money markets
• The IS curve– deriving the IS curve
– elasticity of the IS curve
– shifts in the IS curve
• The goods and money markets
• The IS curve– deriving the IS curve
– elasticity of the IS curve
– shifts in the IS curve
The IS curveThe IS curve
Inje
ctio
ns,
With
dra
wa
lsR
ate
of i
nte
rest
O
O
r1
I1 (J1)
S1 (W1)
Y1
Y1
I2 (J2)
S2 (W2)
Y2
r2
IS(J = W)
b
a
ISLM ANALYSISISLM ANALYSIS
• The goods and money markets
• The IS curve– deriving the IS curve
– elasticity of the IS curve
– shifts in the IS curve
• The LM curve
• The goods and money markets
• The IS curve– deriving the IS curve
– elasticity of the IS curve
– shifts in the IS curve
• The LM curve
ISLM ANALYSISISLM ANALYSIS
• The goods and money markets
• The IS curve– deriving the IS curve
– elasticity of the IS curve
– shifts in the IS curve
• The LM curve– deriving the LM curve
• The goods and money markets
• The IS curve– deriving the IS curve
– elasticity of the IS curve
– shifts in the IS curve
• The LM curve– deriving the LM curve
O O
Ra
te o
f in
tere
st
Ra
te o
f in
tere
st
Money National income
Y1
L'
Assume that at a level ofnational income, Y1,
the demand for money is L'
Money market equilibrium: deriving the LM curveMoney market equilibrium: deriving the LM curve
O O
Ra
te o
f in
tere
st
Ra
te o
f in
tere
st
Money National income
Y1
MS
L'
Assume that at a level ofnational income, Y1,
the demand for money is L'
Money market equilibrium: deriving the LM curveMoney market equilibrium: deriving the LM curve
O O
Ra
te o
f in
tere
st
Ra
te o
f in
tere
st
Money National income
Y1
MS
r1 r1
L'
Assume that at a level ofnational income, Y1,
the demand for money is L'
Money market equilibrium: deriving the LM curveMoney market equilibrium: deriving the LM curve
O O
Ra
te o
f in
tere
st
Ra
te o
f in
tere
st
Money National income
Y1
MS
r1 r1
L'
c
Assume that at a level ofnational income, Y1,
the demand for money is L'
Money market equilibrium: deriving the LM curveMoney market equilibrium: deriving the LM curve
O O
Ra
te o
f in
tere
st
Ra
te o
f in
tere
st
Money National income
Y1
MS
r1 r1
Y2
L"L'
c
Now assume that at the higher level of national income, Y2,
the demand for money rises to L"
Money market equilibrium: deriving the LM curveMoney market equilibrium: deriving the LM curve
O O
Ra
te o
f in
tere
st
Ra
te o
f in
tere
st
Money National income
Y1
MS
r1 r1
r2 r2
Y2
L"L'
c
Now assume that at the higher level of national income, Y2,
the demand for money rises to L"
Money market equilibrium: deriving the LM curveMoney market equilibrium: deriving the LM curve
O O
Ra
te o
f in
tere
st
Ra
te o
f in
tere
st
Money National income
Y1
MS
r1 r1
r2 r2
Y2
L"L'
c
d
Now assume that at the higher level of national income, Y2,
the demand for money rises to L"
Money market equilibrium: deriving the LM curveMoney market equilibrium: deriving the LM curve
O O
Ra
te o
f in
tere
st
Ra
te o
f in
tere
st
Money National income
Y1
LMMS
r1 r1
r2 r2
Y2
L"L'
c
d
Now assume that at the higher level of national income, Y2,
the demand for money rises to L"
Money market equilibrium: deriving the LM curveMoney market equilibrium: deriving the LM curve
ISLM ANALYSISISLM ANALYSIS
• The goods and money markets
• The IS curve– deriving the IS curve
– elasticity of the IS curve
– shifts in the IS curve
• The LM curve– deriving the LM curve
– elasticity of the LM curve
• The goods and money markets
• The IS curve– deriving the IS curve
– elasticity of the IS curve
– shifts in the IS curve
• The LM curve– deriving the LM curve
– elasticity of the LM curve
O O
Ra
te o
f in
tere
st
Ra
te o
f in
tere
st
Money National income
Y1
LMMS
r1 r1
r2 r2
Y2
L"L'
c
d
The LM curveThe LM curve
ISLM ANALYSISISLM ANALYSIS
• The goods and money markets
• The IS curve– deriving the IS curve
– elasticity of the IS curve
– shifts in the IS curve
• The LM curve– deriving the LM curve
– elasticity of the LM curve
– shifts in the LM curve
• The goods and money markets
• The IS curve– deriving the IS curve
– elasticity of the IS curve
– shifts in the IS curve
• The LM curve– deriving the LM curve
– elasticity of the LM curve
– shifts in the LM curve
O O
Ra
te o
f in
tere
st
Ra
te o
f in
tere
st
Money National income
Y1
LMMS
r1 r1
r2 r2
Y2
L"L'
c
d
The LM curveThe LM curve
ISLM ANALYSISISLM ANALYSIS
• The goods and money markets
• The IS curve– deriving the IS curve
– elasticity of the IS curve
– shifts in the IS curve
• The LM curve– deriving the LM curve
– elasticity of the LM curve
– shifts in the LM curve
• Equilibrium in the model
• The goods and money markets
• The IS curve– deriving the IS curve
– elasticity of the IS curve
– shifts in the IS curve
• The LM curve– deriving the LM curve
– elasticity of the LM curve
– shifts in the LM curve
• Equilibrium in the model
O
Ra
te o
f in
tere
st
National income
LM
IS
Equilibrium in both the goods and money marketsEquilibrium in both the goods and money markets
O
Ra
te o
f in
tere
st
National income
IS
Y1
a
Assume that national incomeis currently at a level of Y1
LM
Equilibrium in both the goods and money marketsEquilibrium in both the goods and money markets
O
Ra
te o
f in
tere
st
National income
IS
r1
Y1
a
This gives a rate ofinterest of r1 (point a)
LM
Equilibrium in both the goods and money marketsEquilibrium in both the goods and money markets
O
Ra
te o
f in
tere
st
National income
IS
r1
Y1 Y2
a
But at r1, national incomeis below the goods market
equilibrium level (Y2)
b
LM
Equilibrium in both the goods and money marketsEquilibrium in both the goods and money markets
But as income rises, so therewill be a movement up theLM curve. The interest ratewill rise, thereby reducingnational income below Y2.
O
Ra
te o
f in
tere
st
National income
IS
r1
Y1 Y2
a b
LM
Equilibrium in both the goods and money marketsEquilibrium in both the goods and money markets
O
Ra
te o
f in
tere
st
National income
IS
re
Ye
LM
Equilibrium in both the goods and money marketsEquilibrium in both the goods and money markets
ISLM ANALYSISISLM ANALYSIS
• Full effects of changes in the goods and money markets
– effects of changes in the goods market
• Full effects of changes in the goods and money markets
– effects of changes in the goods market
O
Ra
te o
f in
tere
st
National income
LM
IS
r1
Y1
ISLM analysis of changes in the goods and money marketsISLM analysis of changes in the goods and money markets
O
Ra
te o
f in
tere
st
National income
IS1
r1
Y1
IS2
r2
Y2
A rise ininjections
LM
ISLM analysis of changes in the goods and money marketsISLM analysis of changes in the goods and money markets
ISLM ANALYSISISLM ANALYSIS
• Full effects of changes in the goods and money markets
– effects of changes in the goods market
– effects of changes in the money market
• Full effects of changes in the goods and money markets
– effects of changes in the goods market
– effects of changes in the money market
O
Ra
te o
f in
tere
st
National income
LM1
IS
r1
Y1
LM2
r3
Y3
A rise in themoney supply
ISLM analysis of changes in the goods and money marketsISLM analysis of changes in the goods and money markets
ISLM ANALYSISISLM ANALYSIS
• Full effects of changes in the goods and money markets
– effects of changes in the goods market
– effects of changes in the money market
– effects of changes in both markets
• Full effects of changes in the goods and money markets
– effects of changes in the goods market
– effects of changes in the money market
– effects of changes in both markets
LM2LM1
O
Ra
te o
f in
tere
st
National income
IS1
r1
Y1
IS2
Y4
A rise in bothinjections andmoney supply
ISLM analysis of changes in the goods and money marketsISLM analysis of changes in the goods and money markets
ISLM ANALYSISISLM ANALYSIS
• Full effects of changes in the goods and money markets
– effects of changes in the goods market
– effects of changes in the money market
– effects of changes in both markets
• Deriving an AD curve from the ISLM model
• Full effects of changes in the goods and money markets
– effects of changes in the goods market
– effects of changes in the money market
– effects of changes in both markets
• Deriving an AD curve from the ISLM model
Rat
e of
inte
rest
(r)
Pric
e le
vel (
P)
National income (Y)
National income (Y)
LM1
IS
Y1
r1
P1
Deriving the AD curve from an ISLM diagramDeriving the AD curve from an ISLM diagram
Y1
a'
a
Rat
e of
inte
rest
(r)
Pric
e le
vel (
P)
National income (Y)
LM1LM2
IS
AD
Y1
Y1Y2
r2
r1
P2
P1
Deriving the AD curve from an ISLM diagramDeriving the AD curve from an ISLM diagram
a'
a
Y2
b'
b
National income (Y)
Relationship between the Money and Goods MarketsRelationship between the Money and Goods Markets
Taking Inflation into Account
Taking Inflation into Account
TAKING INFLATION INTO ACCOUNTTAKING INFLATION INTO ACCOUNT
• The policy of inflation targeting
• AD and AS plotted against inflation
– the inflation target line
• The policy of inflation targeting
• AD and AS plotted against inflation
– the inflation target line
O
National income
Rat
e of
infla
tion
(P).
Ptarget
.
The inflation target lineThe inflation target line
TAKING INFLATION INTO ACCOUNTTAKING INFLATION INTO ACCOUNT
• The policy of inflation targeting
• AD and AS plotted against inflation
– the inflation target line
– the ADI curve
• The policy of inflation targeting
• AD and AS plotted against inflation
– the inflation target line
– the ADI curve
O
National income
ADI
Rat
e of
infla
tion
(P).
Ptarget
.
AD plotted against inflationAD plotted against inflation
Y1
the ADI curve
• why downward sloping?
• what determines the slope?
• movements along and shifts in the ADI curve
the ADI curve
• why downward sloping?
• what determines the slope?
• movements along and shifts in the ADI curve
TAKING INFLATION INTO ACCOUNTTAKING INFLATION INTO ACCOUNT
• The policy of inflation targeting
• AD and AS plotted against inflation
– the inflation target line
– the ADI curve
• why downward sloping?
• what determines the slope?
• movements along and shifts in the ADI curve
– the ASI curve
• The policy of inflation targeting
• AD and AS plotted against inflation
– the inflation target line
– the ADI curve
• why downward sloping?
• what determines the slope?
• movements along and shifts in the ADI curve
– the ASI curve
O
ASI
Y1
National income
ADI1
Rat
e of
infla
tion
(P).
Ptarget
. a
AD and AS plotted against inflationAD and AS plotted against inflation
TAKING INFLATION INTO ACCOUNTTAKING INFLATION INTO ACCOUNT
• Response to change in aggregate demand and supply
– a change in aggregate demand
• Response to change in aggregate demand and supply
– a change in aggregate demand
O
ASI
Y1
National income
ADI1
Rat
e of
infla
tion
(P).
Ptarget
.
ADI2
Y2
P2
.a
b
AD and AS plotted against inflationAD and AS plotted against inflation
Y3
c
O
ASI
Y1
National income
ADI1
Rat
e of
infla
tion
(P).
Ptarget
.
ADI2
Y2
P2
.a
b
AD and AS plotted against inflationAD and AS plotted against inflation
TAKING INFLATION INTO ACCOUNTTAKING INFLATION INTO ACCOUNT
• Response to change in aggregate demand and supply
– a change in aggregate demand
– a change in aggregate supply
• Response to change in aggregate demand and supply
– a change in aggregate demand
– a change in aggregate supply
TAKING INFLATION INTO ACCOUNTTAKING INFLATION INTO ACCOUNT
• Response to change in aggregate demand and supply
– a change in aggregate demand
– a change in aggregate supply
• a temporary supply shock
• Response to change in aggregate demand and supply
– a change in aggregate demand
– a change in aggregate supply
• a temporary supply shock
O
ASI1
National incomeY1
ADI1
Rat
e of
infla
tion
(P).
Ptarget
.
Y2
P2
.a
ASI2
b
The effects of a increase in aggregate supply(a) a temporary increase in aggregate supply
The effects of a increase in aggregate supply(a) a temporary increase in aggregate supply
TAKING INFLATION INTO ACCOUNTTAKING INFLATION INTO ACCOUNT
• Response to change in aggregate demand and supply
– a change in aggregate demand
– a change in aggregate supply
• a temporary supply shock
• a permanent change in aggregate supply
• Response to change in aggregate demand and supply
– a change in aggregate demand
– a change in aggregate supply
• a temporary supply shock
• a permanent change in aggregate supply
O
ASI1
Y1
National income
ADI1
The effects of a increase in aggregate supply(b) a permanent increase in aggregate supply
The effects of a increase in aggregate supply(b) a permanent increase in aggregate supply
Rat
e of
infla
tion
(P).
Ptarget
.
Y2
P2
.a
ASI2
b
ADI2
Y3
c
Central bank cutstarget interest rate
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