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Expenditure and interest rates
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Expenditure and interest rates
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ES20013 – intermediate macroeconomics 1Expenditure and interest rates
IS-LM
- IS (investment savings) LM (liquidity preference-money supply)
- The simplest model to explain the data is the IS-LM (closed
economy)
- Allows us to analyse
o Output, consumption, and investment
o The interest rates
o The money supply
- We can use it to explore the effects of
o Fiscal policy (gov expenditure and tax)
o Monetary policy (interest rates and the money supply)
o Shocks
- Although useful it isn’t perfect
o Maybe over simple
o Makes unrealistic assumptions
o It assumes prices are fixed (no inflation)
- The IS relationship reflects expenditure and how this is affected
by the interest rates
- It is based on analysing the demand for goods (not the supply
though)
- It hasn’t changed for 60 years
- The LM relationship reflects monetary policy
- We will consider three varieties of the LM relationship
o Classic LM – based on money supply and demand
o A fixed interest
o A monetary policy rule: here the central bank raises
interest rates as output increases
IS
- IS combines four things
o The definition of national income
, Y=C+I+G
o A simple consumption functions
C = cY
o A simple investment function
I = I* - bi
o Assuming the government expenditure is exogenous
o Combining these
o Or (this is the relationship plotted as the IS curve)
o If gov expense increases, then IS shifts up and if gov
spending goes down so does the IS curve
1. Consumption becomes more sensitive to output
a. If consumption goes up the slope coefficient falls so it
becomes flatter
2. Investment becomes more sensitive to the interest rate
a. If b increases the slope coefficient also falls meaning it will
be flatter
3. Suppose the C = 0.8 and b = 10. Also I* = 10 ;G = 10. If the
interest rate is 4% what is the output?
a. 1/0.2 (20) – 10/0.2 (0.04) = 98
4. Without calculations. By how much must g increase in order to
increase output by 25? Why?
a. By 5 as 1-c/b is the increase in output which is 5 times so
5 x 5 will give an increase in 25
Classic LM
- We begin with the classic LM curve
- Money demand is assumed to depend on output and the
interest rates
o M/P = kY – hi
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