ECO2004 - Macroeconomics 2 Full Summary

GOODS AND FINANCIAL MARKETS

Chapter 5



Equilibrium:

Y = C(Y - T) + I + G

- In the simple model, the interest rate did not affect the demand for goods



Investment relation: Investment is a function of income (Y) and interest rate

I = I( Y, I )

Depends on two factors:

1. Level of sales ( + )
2. Interest rate ( - )
I = I ( Y, I ) (+ ,− )



New Equilibrium

Y = C(Y - T) + I(Y,i) + G




Determining the Output:

- Equilibrium requires that demand
for goods be equal to output
- For given Interest rate, demand for
goods is an increasing function of
output
- Increase in Output leads to increase
in income which leads to increase in
disposable income ( Yd ) and
Consumption C
- Increase output increase investment
- Increase output leads to increase
demand

,ZZ Line – Relationship between demand and output at a given interest rate

 Investment isn’t fixed, the sum of an increase in consumption and investment may exceed
the initial increase in output
 ZZ Line flatter than 45-degree line if increase in C and I




Increase in Interest rate decreases the
demand for goods at any level of output,
decreasing equilibrium output




IS curve downward sloping because
equilibrium in goods market implies that
an increase in the interest rate leads to
decrease in output

, SHIFTS OF THE IS CURVE

- Changes in factors that decrease the demand for goods at given the interest rate, shift the IS
curve to the LEFT
- Example: Increase in tax or decrease in government spending
- Changes in factors that increase the demand for goods, shift IS curve to the RIGHT
- Such as changes in autonomous consumption, government spending or taxes

d




FINANCIAL MARKETS AND LM RELATION

Interest rate is determined by the equality of the supply of and the demand for money

M = RY L (i)

M = Nominal money stock

RYL (i) = Demand for money

RY = Nominal income

i = Nominal interest rate



Recall that Nominal income divided by the price level= real income. Therefore, dividing both sides of
the above equation by the price level gives you




LM Relation: In equilibrium, the real money supply is equal to the real money demand, which
demands on real income, Y, and the interest rate, I

, Deriving the LM Curve:



An increase in income leads, at a given interest
rate, to an increase in the demand for money.
This leads to an increase in the equilibrium
interest rate




- Equilibrium in financial markets implies that an increase in income leads to an increase in the
interest rate. The LM curve is therefore upward- sloping
- LM illustrates the relationship between the interest rate (vertical axis) and income
(horizontal axis).




Shift of the LM Curve




 An increase in money leads the LM
curve to shift down.
 Equilibrium in financial markets implies
that, for a given real money supply, an
increase in the level of income, which
increases the demand for money, leads
to an increase in the interest rate. This
relation is represented by the upward-
sloping LM curve.
 An increase in the money supply shifts
the LM curve down; a decrease in the
money supply shifts the LM curve up.