IS curve

1
IS curve

• The IS curve shows the relationship between
  interest rates generated in financial markets and
  the equilibrium level of income the economy
  gravitates toward given these rates.
• The IS curve is based on the Keynesian model of
  chapter 20

2
Derivation of the IS curve

• Yad,Y

Yad i6
Yad i7
Yad i8
6605
6545
6665
3
Plotting these same points in i and Y space

• i

8
7
6
IS
6605
6545
6665
4
The IS curves position

• The IS curves position is determined by the
  factors that determine Yad curves position .
• Anything ,other than a drop in interest rates,
  that would push Yad to the left (up) will be
  represented by the IS curve shifting to the
  right.
• And anything, other than a rise in interest
  rates, that would push Yad to the right (down)
  will be represented by the IS curve shifting to
  the left

5
An increase in real wealth for example.
Yad'

• Yad

B
Yad
A
Y
i
B
A
IS
IS
Y
6
Definition of the LM curve

• The LM curve shows the relationship between the
  equilibrium level of income the economy and
  interest rates financial markets gravitate toward
  given this level of real income.
• The LM curve is based on the analysis of the
  money market carried out in chapter 5.

7
Derivation of the LM curve

• Hold factors that affect MD (besides real
  income) constant.
• The higher real income is, the higher the demand
  for money. The higher the demand for money, the
  higher the equilibrium rate of interest will be.
• The lower real income is, the lower the demand
  for money. The lower the demand for money, the
  lower the equilibrium rate of interest will be.

8
The above is the basis of the LM curve.

i
Ms
c
MD
b
a
MD
MD
9

• Lets say that points a, b and c correspond to
  6000 billion dollar, a 6500 billion and a 7000
  billion levels of equilibrium income.

10
Putting these points together generates the LM
curve
i
LM
c
b
a
6000
6500
7000
11
The LM curves position

• The LM curves position is determined by the
  factors that determine MD and MS curves
  positions .
• Anything, other than a drop in income, that would
  push MD to the left (down) will be represented by
  the LM curve shifting to the right. (A drop in
  prices or ie falling.)

12
LM curves position (contd)

• Anything other than a rise in income that would
  push MD to the right (up) will be represented by
  the LM curve shifting to the left. (A rise in
  prices or an increase ie.)
• Anything, that would push the money supply curve
  to the right (left) will cause the LM to shift in
  the same direction.

13

• For example, the Fed on net buying securities
  from the public will increase the money supply,
  push the MS curve to the right and be represented
  by the LM curve shifting to the right as well.

14
Combining IS and LM

• The IS curve shows the relationship between
  interest rates generated in financial markets and
  the equilibrium level of income given these
  rates.
• The LM curve shows the relationship between the
  level of income and the interest rates that
  results in financial market equilibrium

15

• Therefore the point at which IS and LM intersect
  represents equilibrium in BOTH financial markets
  AND in the rest of the economy and equilibrium i
  and Y (interest rates and real income).

LM
i
IS
Y
16
A brief discussion of methodology

• Key elements of any economic model such as the
  ISLM model
• Exogenous variables.
• Endogenous variables.
• Behavioral equations and identities.
• Equilibrium conditions.

17
Exogenous variables

• Exogenous variables are determined outside the
  model (and therefore assumed constant). If they
  change, we do NOT ask why, we simply assess the
  impact of their changing on the models
  endogenous variables.

18
In the basic macromodel (the Keynesian cross of
chapter 23) think of that models exogenous
variables as guests seated around a table .
CC
Expected profits(LT)
Y
Real wealth
i
Pk
mpc
I go here!
Given where everyone else is sitting, Y goes in
this spot!
19
Endogenous variables

• Variables we DO want to explain. Their values
  are determined by the model (like Y in the basic
  macro model). Basically the model is designed to
  show how the endogenous variables are influenced
  by the exogenous variables.

20
Behavioral equations and identities.

• Equations that describe how variables in the
  model (both endogenous and exogenous) fit
  together.
• For example, the consumption function of chapter
  20 is an example of a behavioral equation showing
  how consumer spending relates to real income,
  interest rates, real wealth, and consumer
  confidence.
• The equation Yad CI is an example of an
  identity, an equation that is true by definition.

21
Equilibrium conditions

• Relationships that results once things have
  settled down. In ISLM you have two such
  relationships
• (1) YYad
• Equilibrium in the goods market.
• (2) MdMs
• Equilibrium in the money market.

22
Comparative statics

• Once we have defined equilibrium conditions we
  are ready to show endogenous variables are
  influenced by the exogenous variables.
• In the context of ISLM this means asking such
  important questions such as the impact of the FED
  targeting a lower fed funds rate on other market
  interest rates and the level of real income.

23
Limits of models

• Imitating the methods of the hard sciences but
  materials we deal with are inherently different.

24
Physics versus economics

• Physics
• Many general stable relationships with reliable
  constants (what is assumed exogenous IS in
  reality constant)
• For example, the mass of two objects as you
  derive gravitational force are assumed constant
  and in reality ARE constant.

• Economics
• Many relatively unstable relationships with few
  reliable constants.
• What is assumed constant in a model often is in
  reality anything but constant.
• For example, both real income and the velocity of
  money in the traditional quantity theory of
  money were assumed constant but in reality both
  are endogenous variables.

25
Models in economics nonetheless incredibly useful

• These simplified versions of the real world allow
  us to see workings of more complicated real world
  economies.
• Elaborations and refinements possible. In chapter
  22,for example, we can and will make the price
  level endogenous.
• Many studies of learning and what is known as the
  transference of knowledge indicate that
  understanding of general principles are far more
  valuable than a lot of specific detailed
  information.
• In short, although it takes more time and effort,
  really understanding something is vital. It is
  far more important than simply committing to
  memory the right answers.

26
Economists should strive for what Aristotle
called for in his Nichomedian Ethics

• Our discussion will be adequate if it has as
  much clearness as the subject matter admits of.