Macroeconomics for Decision Making
Macroeconomics for
Decision Making
IS Curve
RMIT Classification: Trusted
IS Curve
Product market:
Real GDP/income/economic activity depends on
the level of autonomous planned spending.
RGDP = Y = AE = C+I+G+NX
Autonomous planned spending (Ca and Ip) is
affected by (“depends on”) interest rates. Ap
(Y, r)
– As r↑, the cost of borrowing rises and interest-
sensitive consumption and investment ↓.
IS curve: is the schedule that identifies the
combinations of income and interest rate at which
the product/commodity market is in equilibrium.
Deriving the IS Curve
RMIT Classification: Trusted
Deriving the IS Curve
Ep 45o Ep1=Ap1+cY
C
RGDP = Y = AE = C+I+G+NX Ep0=Ap0+cY
A Ep2=Ap2+cY
r Y2 Y0 Y1 Y
r
r2 B r2 B
A A
r0 r0
r1 C r1 C
Ap IS
Ap1 Ap Y2 Y0 Y1 Y
Ap2 Ap0
IS Curve RMIT Classification: Trusted
IS Curve
r2 B
r0 A
r1 C
IS
Y
Y2 Y0 Y1
IS Curve (Y=kAp)
RMIT Classification: Trusted
IS Curve (Y=kAp)
Shifts: any increase in planned autonomous
spending shifts the IS curve to the right (and vice
versa)
– The IS curve shifts by the change in Ap times the
multiplier.
Slope: the slope of the IS curve reflects the
responsiveness of Ap to interest rates.
– The more responsive Ap is to interest rates, the
flatter the IS curve.
– The higher the multiplier, the flatter the IS curve.
Extended IS: Y=k(Ap – br), where b is interest
responsiveness
RMIT Classification: Trusted
Product Market and Money Market Combined
Product Market and Money Market
Combined
(Deriving the LM Curve)
LM Curve
RMIT Classification: Trusted
LM Curve
The LM Curve shows all the possible
combinations of Y and r such that the money
market is in equilibrium.
r (M/P)s r LM
r1 B r1 B
r0 A r0 A
Md1
(Y = Y1)
Md0
(Y = Y0)
M/P Y0 Y1 Y
LM Curve RMIT Classification: Trusted
LM Curve
• LM curve: is the schedule that identifies the combinations of
income and interest rate at which the money market is in
equilibrium- where the demand for real money balances is
equal to the supply.
• At equilibrium, real MS equals real Md:
𝑀𝑠Τ𝑃 = 𝑀Τ𝑃 𝑑 = ℎ𝑌 − 𝑓𝑟
The parameters h and f reflect the sensitivity of real money
demand to income and interest rates
Solving for r because it is the dependent variable in the
LM curve yields: 𝑀Τ𝑃 = ℎ𝑌 − 𝑓𝑟
𝑓𝑟 = ℎ𝑌 − 𝑀Τ𝑃
1 M h
S
𝑓𝑟 1
r = − + Y = ℎ𝑌 − 𝑀Τ𝑃
f P f 𝑓 𝑓
1
𝑟 = ℎ𝑌 − 𝑀Τ𝑃
𝑓
Positions off the LM Curve RMIT Classification: Trusted
Positions off the LM Curve
r (M/P)s r LM
r1 C r1
C
r0 A B r0 A
B
Md1 EDM
(Y = Y1)
Md0
(Y = Y0)
M/P Y0 Y1 Y
Deriving the LM Curve RMIT Classification: Trusted
Deriving the LM Curve
Excess supply of money
Excess demand for money
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What shifts and rotates the LM Curve?
RMIT Classification: Trusted
What shifts and rotates the LM
Curve?
The real money
supply is • If MS ➔ LM shifts → right
constant along • If P ➔ LM shifts → left
the LM curve:
Anything that
affects the slope • If h ➔ LM becomes
term will cause a steeper
rotation of the • If f ➔ LM becomes flatter
LM curve:
𝑀Τ𝑃 = ℎ𝑌 − 𝑓𝑟
RMIT Classification: Trusted
IS-LM Model
IS-LM Model
The General Equilibrium
The General Equilibrium
r LM
r0 A
IS Y
Y0
Monetary Policy RMIT Classification: Trusted
Monetary Policy
Interest rate (r) LM0
ESM LM1
E0
r0
E1
r1
IS0
Y0 Y1 Real Income
(Y)
Expansionary Fiscal Policy
RMIT Classification: Trusted
Expansionary Fiscal Policy
Interest rate (r) LM
r1 E1
E0
r0
IS1
IS0
Y0 Y1 Real Income
(Y)
RMIT Classification: Trusted
Policy Effectiveness
Policy Effectiveness
Fiscal Policy and “Crowding Out”
RMIT Classification: Trusted
Fiscal Policy and
“Crowding Out”
When the government borrows funds to finance
large deficits, it increases the demand for
loanable funds. Government borrowing
competes with private borrowing for the
available supply of funds. The additional
government borrowing to finance a larger deficit
will drive up the interest rate.
r ➔ Private Autonomous Spending
The reduction in the amount of consumption
and/or investment spending due to an increase
in G (or fall in T) is known as “Crowding Out”
Crowding Out RMIT Classification: Trusted
Crowding Out
Interest rate (r)
LM
r1 E1 Crowding
E0 out
r0
IS1
IS0
Y0 Y1 Y2 Real Income (Y)
Expansionary Fiscal Policy with Accommodating Monetary Policy
RMIT Classification: Trusted
Expansionary Fiscal Policy with
Accommodating Monetary Policy
Can crowding out be avoided?
Yes! If the central bank simultaneously MS ➔ r
Interest rate (r) LM0
LM1
r1 E1
E0
r0 E2
IS1
IS0
Y0 Y1 Y2 Real Income (Y)
Expansionary Fiscal Policy with Contractionary Monetary Policy
RMIT Classification: Trusted
Expansionary Fiscal Policy with
Contractionary Monetary Policy
LM1
Interest rate (r)
LM0
r2 E2
E1
r1
E0
r0
IS1
IS0
Y0 Y1 Real Income (Y)
Y2
Policy Effectiveness
RMIT Classification: Trusted
Policy Effectiveness
Any change in the responsiveness of real money demand to real
income and interest rates will change the slope of the LM curve.
▪ If the h parameter increases, money demand becomes more responsive
to income and the LM curve becomes steeper
▪ If the f parameter increases, money demand becomes more responsive
to interest rates the money demand and LM curve becomes flatter
r r
kΔY
MD=hY-f’r
MD=hY1-fr
MD=hY0-fr MD=hY-fr
Real Money Balances M/P
Policy Effectiveness
RMIT Classification: Trusted
Policy Effectiveness
Responsiveness of
interest-sensitive
r
consumption and
investment to interest
rates
r0
r1
ID (elastic)
ID (inelastic)
ID
Fiscal Policy Effectiveness
Fiscal policy is strong when the LM curve is relatively flat Fiscal policy is weak when the LM curve is steep
RMIT Classification: Trusted
Fiscal Policy Effectiveness
Fiscal policy is strong when the LM curve is relatively flat
Fiscal policy is weak when the LM curve is steep
LM0
Interest rate (r) Interest rate (r)
r1 E1
LM
r1 E1
r0 r0
E0 E0
IS1 IS1
IS0 IS0
Y0 Y1 Real Y0 Y1 Real
Income (Y) Income (Y)
Fiscal Policy Effectiveness RMIT Classification: Trusted
Fiscal policy is strong when the IS curve is very steep Fiscal policy is weak when the IS curve is relatively flat
Fiscal Policy Effectiveness
Fiscal policy is strong when the IS curve is very steep
Fiscal policy is weak when the IS curve is relatively flat
Interest rate (r)
Interest rate (r)
LM0
LM0
r1 E1 E1
r1
E0
r0 E0
r0
IS1
IS0
IS1
IS0
Y0 Y1 Real
Y0 Y1 Real
Income (Y)
Income (Y)
Monetary Policy Effectiveness RMIT Classification: Trusted
Monetary policy is strong when the IS curve is relatively flat Monetary policy is weak when the IS curve is very steep
Monetary Policy Effectiveness
Monetary policy is strong when the IS curve is relatively flat
Monetary policy is weak when the IS curve is very steep
Interest rate (r) Interest rate (r)
LM0
LM0
LM1
LM 1
E0 E0
r0 r0
r1
E1 IS r1
0
E1
IS
0
Y0 Y1 Real Y0 Y1 Real
Income (Y) Income (Y)
Monetary policy is strong when the LM curve is steep Monetary policy is weak when the LM curve is relatively flat
RMIT Classification: Trusted
Monetary Policy Effectiveness
Monetary policy is strong when the LM curve is steep
Monetary policy is weak when the LM curve is relatively flat
LM0 LM1
Interest rate (r) Interest rate (r)
LM0
E0 E0
r0 LM 1 r0
r1
E1
r1 E1
IS IS
0 0
Y0 Y1 Real Y0 Y1 Real
Income (Y) Income (Y)
Macroeconomics for Decision Making WORKSHOP 10
Macroeconomics for
Decision Making
WORKSHOP 10
RMIT Classification: Trusted
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