Felicia Irene Week 7

A S S I G N M E N T
W E E K 7
FELICIA IRENE - 202250351
5. It is possible that the interest rate might affect consumption spending. An increase
in the interest rate could, in principle, lead to increases in saving and therefore a
reduction in consumption, given the level of income. suppose that consumption is, in
facr, reduced by an increase in the interest rate. How will the IS curve be affected
Answer
The IS curve shows the goods market equilibrium in an economy. The goods market
is in equilibrium when aggregate demand for goods is equal to its supply.
Alternatively, the economy is said to be in equilibrium when desired national saving
equals desired investment. So the 'I' in the IS curve stands for investment and the 'S'
represents saving. The IS curve is thus a downward sloping curve which shows the
real interest rate that clears the goods market, for a given level of output or income Y.
At every point on this curve desired savings equals desired investment.
If an increase in the interest rate induces people to save more and consume less,
then aggregate demand for goods and services will fall. In such a situation if output
remains at the original level then this will cause an excess supply of goods and
services. So for the goods market to reach equilibrium, total output has to fall. If this
happens then we will move to a point on the IS curve with a higher interest rate and
lower output. So the IS curve will remain at its original position and there will only be
a movement along the curve.
MONEY, INTEREST,
AND INCOME
Felicia Irene - 202250351
Monetary policy plays a central role in
the determination of income and
employment. Interest rates are a
significant determinant of aggregate
spending, and the Federal Reserve,
which controls money growth and
interest rates, is the first institution to
be blamed when the economy gets into
trouble. The model we introduce in
this chapter, the IS-LM model, is the
core of short-run macroeconomics. It
maintains the spirit and, indeed, many
details of the model
The Federal Reserve enters the picture through its role in setting the supply of
money. Interest rates and income are jointly determined by equilibrium in the
goods and money markets. We maintain the assumption that the price level
does not respond when aggregate demand shifts.
Understanding the money market and interest rates is important for three
reasons:
Monetary policy works through the money market to affect output and
employment.
The analysis qualifies the conclusions, which lays out the logical structure
of the model. So far, we have looked at the box labeled “Goods market.” By
adding the assets markets, we provide a fuller analysis of the effect of
fiscal policy, and we introduce monetary policy.
Interest rate changes have an important side effect. The composition of
aggregate demand between investment and consumption spending
depends on the interest rate.
We derive a key relationship the IS curve that shows
combinations of interest rates and levels of income at
which the goods markets clear. We show that the
demand for money depends on interest rates and
income and that there are combinations of interest
rates and income levels the LM curve at which the
money market clears. The IS-LM model continues to be
used today, 80 years after it was introduced, because it
provides a simple and appropriate framework for
analyzing the effects of monetary and fiscal policy on
the demand for output and on interest rates.
THE GOODS MARKET AND THE IS CURVE
The IS curve (or schedule) shows combinations of interest rates and levels of
output such that planned spending equals income.
The Investment demand schedule ; investment spending (I) has been treated
as entirely exogenous.
Investment and the interest rate :
where i is the rate of interest and the coefficient b measures the

responsiveness of investment spending to the interest rate. I now denotes
autonomous investment spending, that is, investment spending that is
independent of both income and the rate of interest
the investment schedule of equation (1),
shows for each level of the interest rate the
amount that firms plan to spend on
investment. The schedule is negatively
sloped to reflect the assumption that a
reduction in the interest rate increases the
profitability of additions to the capital stock
and therefore leads to a larger rate of
planned investment spending. The position of
the investment schedule is determined by the
slope the coefficient b in equation (1) and by
the level of autonomous investment
spending, I. If the investment is highly
responsive to the interest rate, a small
decline in interest rates will lead to a large
increase in investment, so the schedule is
almost flat. Conversely, if investment
responds little to interest rates, the schedule
will be more nearly vertical.
THE INTEREST RATE AND AGGREGATE DEMAND :
THE IS CURVE
We can also derive the IS curve by using the goods market equilibrium
condition, that income equals planned spending, or
THE SLOPE OF THE IS CURVE
We have thus seen that the smaller the sensitivity of investment spending to
the interest rate and the smaller the multiplier, the steeper the IS curve. This
conclusion is confirmed using equation. We can turn equation around to
express the interest rate as a function of the level of income :
THE POSITION OF THE IS CURVE
The level of autonomous spending, from equation , is
Accordingly, an increase in government purchases or transfer payments shifts

the IS curve out to the right, with the extent of the shift depending on the size
of the multiplier. A reduction in transfer payments or in government purchases
shifts the IS curve to the left.
THE MONEY MARKET AND THE LM CURVE
The LM curve (or schedule) shows combinations of interest rates and levels of
output such that money demand equals money supply. The LM curve is
derived in two steps. First, we explain why money demand depends on interest
rates and income, emphasizing that because people care about the purchasing
power of money, the demand for money is a theory of real rather than nominal
demand.
THE SUPPLY OF MONEY, MONEY MARKET
EQUILIBRIUM, AND THE LM CURVE
The LM schedule, or money market equilibrium schedule, shows all
combinations of interest rates and levels of income such that the demand for
real balances is equal to the supply. Along the LM schedule, the money market
is in equilibrium.
THE SLOPE OF THE LM CURVE
EQUILIBRIUM IN THE GOODS AND MONEY MARKETS
CHANGES IN THE EQUILIBRIUM LEVELS OF INCOME
AND THE INTEREST RATE
DERIVING THE AGGREGATE DEMAND SCHEDULE
The aggregate demand schedule maps out the IS-LM equilibrium holding
autonomous spending and the nominal money supply constant and allowing
prices to vary.

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A S S I G N M E N T

Investment and the interest rate :

where i is the rate of interest and the coefficient b measures the

Accordingly, an increase in government purchases or transfer payments shifts

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