Macroeconomics_lecture 4- Introduction To Islm

Narsee Monjee Institute of Management Studies

Macroeconomics Introduction to IS-LM Model

Dipankar De Mumbai, October 2007

The Structure of the IS-LM Model INCOME

Assets Market Money Market

Goods market

Bond Market

Demand

Demand

Supply

Supply

Aggregate Demand Output

INTEREST RATES

Monetary Policy

Fiscal Policy

The Goods Market & the IS Curve  The goods market equilibrium is represented by the IS

curve. It is defined as the locus of all combinations of income & rate of interest for which the goods market is in equilibrium  Interest rate & Investment function

– Investment spending is inversely related to interest rate. – Firms borrow to purchase investment goods. The higher the interest rate of borrowing, the lower the profits that firms can expect to make by borrowing to buy new capital goods, & therefore, the less they will be willing to borrow & invest. – Conversely, firms will want to borrow & invest more when interest rates are lower  Specifying the investment function: I = I (r), I’(r) <0  Or,

I = I – b*r, b>0

The Goods Market & the IS Curve  The equation to the IS schedule is given as:

Derivation of IS curve

AD = Y = C(Y) + I(r) + G  The slope of IS curve is negative. Because

– a higher level of the interest rate reduces investment spending, thereby reducing in AD and thus the equilibrium income.  The steepness of the curve depends on

– How sensitive investment spending is to changes in the interest rate? If investment is highly sensitive, then any given change in interest rate would lead to larger fall in investment spending, and hence larger would be decrease in AD & equilibrium income. Flatter would be the IS curve

Shift in the IS Curve  The IS curve is shifted by changes in autonomous spending.

An increase in autonomous spending, including an increase in government expenditure, shifts the IS curve to the right r

IS0

IS1

Effect of increase in Govt. expenditure

Y

The Money Market & the LM Curve  The money market equilibrium is represented by the LM

curve. It is defined as the locus of all combinations of income & rate of interest for which the money market is in equilibrium, i.e. money demand equals money supply  Real & Nominal money demand

– The nominal demand for money is the individual’s demand for a given amount of money, say rupees – The real demand for money is the demand for money expressed in terms of the number of units of goods that money would buy. It is equal to the nominal demand for money divided by the price level – The higher the price level, the more nominal balances a person has to hold to be able to purchase a given quantity of goods

What is Money ? 

‘Money is what money does.’



It is a zero-yielding asset. It is a medium of exchange or means of payment, makes it unnecessary for there to be a “double coincidence of wants”



Functions of Money 

Medium of exchange



Store of value – an asset that maintains value over time (Imagine ice-cream as a store of value!!). An individual holding money can make payments at a future date.



Unit of account is the unit in which prices are quoted & books kept. (In high inflation countries, dollars become the unit of account, even though the local currency continues to be medium of exchange)



Standard of deferred payment - money units are used in long-term transactions, such as loans

Demand for Money 

Demand for real balances are generally for 3 purposes



Transactions motive, which is the demand for money arising from the use of money in making regular payments



Precautionary motive, which is the demand for money to meet unforeseen contingencies



Speculative motive, which is the demand for money arising from uncertainties about the money value of other assets that an individual can hold



Theories of demand for money are built around a trade-off between the benefits of holding more money versus the

Transactions Demand for Money 

Arises from lack disbursements

of

synchronization

of

receipts

&



Trade-off between the amount of interest foregone by holding money and the costs & the inconveniences of holding a small amount of money



Demand for money, therefore, decreases with the interest rate & increases with the cost of transacting.



Demand for money increases with income, but less than proportionately

Precautionary Demand for Money 

Arises because people are uncertain about payments they might want, or have, to make



The more money an individual holds, the less likely he or she is to incur the costs of illiquidity (i.e. not having money immediately).



But the more money he holds, the more interest he has to give up



Technology & the structure of the financial system are important determinants of precautionary demand for money –

Credit cards, debit precautionary demand

cards,

&

smart

cards

reduce

Speculative Demand for Money 

Related to store-of-value function of concentrates on the role of money in the ‘portfolio’ of an individual

money, & investment



Demand for money – the safest asset – depends on the expected yields as well as on the riskiness of other assets



An increase in the expected return on other assets, increases the opportunity cost of holding money, i.e. the return lost by holding money. This lowers money demand.



By contrast, an increase in the riskiness of the returns on other assets increases demand for money

Demand for Real Balances

Md =ky +L (r ), P r

L' ( r ) <0

Md =ky −h * r , kY >0 P

Md/P

Supply of Money  The nominal quantity of money, M, is controlled by the central

bank (RBI in India, Bank of England in UK, etc) Constituents of Money supply M1= M2= M3= M4=

High Powered Money (H)  It is the monetary base, consists of currency (notes+coins) &

banks’ deposits with the central bank  The part of the currency held by the public forms part of the

money supply Central Bank’s control over the Monetary Base, H, is the main route through which it determines Money Supply.

Money Multiplier  The money multiplier is the ratio of the stock of money to

the stock of high-powered money. The MM is larger than 1. M = CU + D H = CU + R CU R cu ≡ ; re ≡ D D M = ( cu + 1) D H = ( cu + re ) D 1+ cu M = H ≡ mm * H ; re + cu 1+ cu mm ≡ re + cu

Money Multiplier  The money multiplier is larger the smaller the reserve ratio, re  The money multiplier is larger the smaller the currency-deposit

ratio. The smaller the cu, the smaller the proportion of H stock that is being used as currency, and larger the proportion that is available to be reserves  The currency-deposit ratio is affected by the cost & convenience

of obtaining cash. ATMs – individuals will carry less cash on average Bank reserves consist of deposits banks hold at the central bank and ‘vault cash’, notes & coins held by banks  Banks hold reserves to meet

–

The demands of their customers for cash

–

Payments their customers make by cheques that are deposited in other banks

The LM Curve 

M We consider the nominal quantity of money as given at the level



P

We assume the

M price P

level to be constant at

,so the real

money supply is at the level 

Money market is in equilibrium when

M Supply = Money Demand Money =kY +L ( r )

P M =kY −h * r P



LM curve can be obtained directly by combining the

The LM Curve 

Positively sloped curve



If there is any increase in income, Y, the higher level of income causes the demand for real balances to be higher at the existing interest level. The interest rate, as result, rises to maintain the money market equilibrium at the new higher level of income. Thus, the positive slope of LM r curve LM Curve

Y

The LM Curve 

The LM curve is steeper when the demand for money responds strongly to income & weakly to interest rates (interest sensitivity or interest responsiveness)

r LM Curve

Y

The LM Curve 

3 possible segments –

Normal positive slope

–

Liquidity Trap

–

Liquidity Gate r

r max

Liquidity Gate Zone, slope zero Speculative demand for money is perfectly inelastic w.r.t change in interest rate

r min Liquidity Trap zone, Speculative demand for slope infinity money is infinitely elastic w.r.t change in interest rate Y

Shift in the LM Curve 

The LM is shifted by changes in the money supply.



An increase in the money supply shifts the LM curve to the right.



At any given level of income, interest rate falls to induce people to hold the larger quantity of money as money supply increases



At each level of interest rate, the level of income has to be r LM higher to raise transactions demand for money, and LM thereby absorb the higher money supply 0

1

Any increase in the money supply shifts the LM Curve to the right

Y

Equilibrium in the Goods & Money market 

Simultaneous determination of equilibrium in both the markets



For this, interest rates & income levels have to be such that both the goods market and the money market are in equilibrium r

LM0

E0 r0

IS0 Y Y0