CH 10 Money Interest Income is-LM Model
CH 10 Money Interest Income is-LM Model
CH 10 Money Interest Income is-LM Model
IMT Ghaziabad
By
Dr. Manas Paul
Term I PGDM 2023-25
Explain these scenarios
Explain the impact of COVID pandemic on economy…
Explain the impact of demonetization?
Explain a temporary adverse supply shock say adverse monsoon
Explain impact of a wave of credit card fraud increases…..
Explain impact of a Rapid rise in ATMs
Explain the impact of Stock market crash….in IS-LM framework
Explain the impact of Improvements in business and consumer confidence
Explain the impact of Corporate accounting scandals like Enron, Worldcom etc
What we intend to do?
Now Investments is no more autonomous but depends on interest rates in
aggregate demand
Three segments of the economy – Goods market, Money Market & asset market
….i.e. introduction of money into model
Maintains the details of earlier model, but adds the interest rate as an additional
determinant of aggregate demand Includes the goods market and the money market, and
their link through interest rates and income.
The Goods Market and the IS Curve
• The IS curve shows combinations of interest rates
and levels of output such that planned spending
equals income
– Derived in two steps:
1. Link between interest rates and investment
2. Link between investment demand and AD
Y (1 c(1 t )) A bi Y G A G bi
Y G ( A bi ) Y G A
i
Gb
A Y
For a given change in Y, the i
associated change in ‘i’ will be b Gb
larger in size as ‘b’ is smaller
and as the multiplier is smaller.
1
where (1 c(1 t )) is the multiplier we derived in the previous
G
chapter
10-11
IS curve shifts -The Role of Multiplier
• Figure alongside shows the [Insert Figure 10-6 here]
AD curves corresponding to
different multipliers
– The coefficient c on the solid
black AD curve is smaller than
that on the dashed AD curve
multiplier larger on the dashed
AD curves
• A given reduction in i, from i1
to i2 raises the intercept of
the AD curves by the same
vertical distance
– Because of the different
multipliers, income rises to Y2’
on the dashed line and Y2 on the
solid line
IS Curve shifts on change in “A”
• Figure alongside shows two [Insert Figure 10-7 here]
different IS curves differ by
levels of autonomous
spending
– Initial AD with A and i1
corresponding point E1 on IS
curve in Figure in panel (b)
– If autonomous spending
increases to A , equilibrium
level of income increases at i1
point E2 in panel (b), shifting
out IS
• The change in income as a
result from a change in
autonomous spending is
Y G A
The Money Market and the LM Curve
• The LM curve shows combinations of interest
rates and levels of output such that money
demand equals money supply equilibrium in
the money market
• The LM curve is derived in two steps:
1. Explain why money demand depends on interest rates and
income
– Theory of real money balances, rather than nominal
2. Equate money demand with money supply, and find
combinations of income and interest rates that maintain
equilibrium in the money market
– (i, Y) pairs meeting this criteria are points on a given LM curve
Demand for Money
• The demand for money, is a demand for real
money balances
– People are concerned with how much their money
can buy, rather than the number of dollars in their
pockets
• The demand for real balances depends on:
Real income: people hold money to pay for their
purchases, which, in turn, depend on income
Interest rate: the cost of holding money
The higher the interest rate, the more expensive it is to hold
money, and the less cash will be held at each level of income
• The demand for money is defined as: L kY hi
Demand for Money Function
L kY hi [Insert Figure 10-8 here]
• The parameters k and h
reflect the sensitivity of the
demand for real balances to
the level of Y and i
• The demand function for real
balances implies that for a
given level of income, the
quantity demanded is a
decreasing function of i
– Figure alongside illustrates the
inverse relationship between
money demand and i money
demand curve
Money Market Equilibrium & LM Curve
• The nominal quantity of money supplied, M, is controlled by the central
bank
– Real money supply is M , where M and P are assumed fixed
P
• The figure below shows combinations of i and Y such that the demand
for real money balances exactly matches the available supply
1 M
– Solving for i:i kY
h P
The relationship (7a) is the LM curve.
The relationship above is the LM curve.
10-18
The Slope of the LM Curve
• The steeper the LM curve:
– The greater the responsiveness of the demand for
money to income, as measured by k
– The lower the responsiveness of the demand for
money to the interest rate, h
These points can be confirmed by experimenting with
Figure or examining equation,
1 M
i kY
h P
A given change in income has a larger effect on i, the larger
is k and the smaller is h
The Position of the LM Curve
• If real money balances increases, the money supply curve shifts
to the right
– To restore equilibrium at the income level Y1, the i must decrease to i2
• The new equilibrium is at point E2
– In panel (b), the LM curve shifts to the down and to the right
• At each level of income, the equilibrium interest rate has to be lower to
induce people to hold the larger real quantity of money
Y
i
i
Y
i
Y
Impact of multiplier and interest rate
sensitivity
• What does a higher Keynesian multiplier imply for IS curve
slope?
Y* Y* Y’
1. Assume the following IS-LM model:
expenditure sector: money sector:
AD = C + I + G + NX M = 500
C = 110 + (2/3)YD P =1
YD = Y - TA + TR md = (1/2)Y + 400 - 20i
TA = (1/4)Y + 20
TR = 80
I = 250 - 5i
G = 130
NX = -30
a. Calculate the equilibrium values of private domestic investment (I), tax revenues
(TA), and real money demand (md).
b. b. How much of private domestic investment (I) will be crowded out if government
purchases are increased by G = 100?
IS = α(∆G) = 2*100 = 200, and the new IS-curve is of the form Y = 1,200 - 10i
Calculate the equilibrium levels of Y and i, and indicate by how much the central bank
will have to change money supply if its goal is to keep interest rates constant after
government purchases are increased by G = 50. (Show your solutions graphically and
mathematically).
ms = md ==> 600 = (1/4)Y + 400 - 15i ==> (1/4)Y = 200 + 15i
==> Y = 4(200 + 15i) ==> Y = 800 + 60i LM-curve
According to the balanced budget theorem, the IS-curve will shift horizontally by the
increase in government purchases, that is, IS = G = TAo = 400
I’ ==> I
i*
==> Y ==> the LM-
curve shifts right
O
Y* Y’ Y’
IS-LM monetary & fiscal policy interaction
Monetary & fiscal policy variables: (M, G, and T ) are exogenous.
• Such interactions may alter the impact of the original policy change.
i3
i2 i2
i2
i1 i1 i1
Solution of IS-LM model
IS curve from real economy LM curve from money mkt
Y AD A c(1 t )Y bi M
kY hi
P
A Y
IS _ Curve : i 1 M
b Gb LM _ curve : i kY
h P
Two equations & two unknowns ‘i’ & ‘y’ hence equation system solvable
Y*
Incorporating the value of ‘i’ from LM curve into IS curve we can solve for eqlm Y*
h G A b G M
Y* *[ 0 ]
h kb G h kb G P
k G A 1 M
i* *[ 0 ]
h kb G h kb G P
Derive the fiscal & money multiplier & relate it to the of IS & LM slopes discussed earlier
Explain these scenarios
Central banks setting interest rates and money supply … are they equivalent?
Why do central banks choose to set interest rate than money supply?
Explain differences in economic adjustments due crowding out effect in short run
and long run
Explain the impact of demonetization in the IS-LM framework?
Explain a temporary adverse supply shock say adverse monsoon in IS-LM
framework
Explain impact of a wave of credit card fraud increases…..in IS-LM framework
Explain impact of a Rapid rise in ATMs….in IS-LM framework
Explain the impact of Stock market crash….in IS-LM framework
Explain the impact of Improvements in business and consumer confidence … in
IS-LM framework
Explain effectiveness of monetary and fiscal policy in a deflationary situation
Explain the impact of Corporate accounting scandals like Enron, Worldcom etc in
IS-LM framework
Demonetization Impact
• LM impact • IS impact
• A certain sum of currency in • Reduced consumption and
circulation (estimate of black investment on complications
money in circulation) was not to carry out transaction due to
expected to return back to the the arrival of Rs. 2000 notes
banking system and their distribution
• To that extent RBI’s liability • Decline in consumer
would reduce… confidence on govt.
• …implies reduction in broad or announcement of heavy
high powered money…. i.e. penalties can affect
∆𝑀 <0 investment as well
• Reduced wealth of which
destroyed or unused cash was
a part
Example: Assume that an economy is characterized by the following equations:
C = 100 + (2/3)*(Disposable income)
T = 600
G = 500
I = 800 – (50/3)r
Md/P = 0.5Y – 50r
The money supply M is 1,200 and the price level P is 1.
Aggregate Demand & Aggregate Supply
• The AS/AD model is the basic macroeconomic tool for
studying output fluctuations and the determination of the
price level and the inflation rate
• AS upward sloped
M
P i I AD
P
&
M
P i I AD
P
• Why is it horizontal?
– Keynesian Economics evolved
during great depression
– High unemployment, idle
Capacity
• Firms could increase
production without
increasing P by putting idle
K (i.e., capital) and N (i.e.,
labor) to work
AS: Classical
• Classical AS:
• Full employment of resources (Fig b)
• Vertical AS?
Keynesian + + 0 0
Classical 0 + + -
Keynesian + + 0
Classical 0 + + -
Intermediate + + + -
http://www.finance-watch.org/hot-topics/understanding-finance/1229-
bank-capital