TERM 1- Credits 3 (Core)

Prof Madhu & Prof Rajasulochana

TAPMI, Manipal
Session 12

Equilibrium in the Goods and Money Market

The IS and LM schedules intersect
to bring about simultaneous
equilibrium in the goods and
money markets at point E,
corresponding to the pair (i0, Y0)

Numerical problem

1. Derive the IS curve

2. Derive the LM curve
3. What are the equilibrium
levels of income and the
interest rate?
4. Depict the equilibrium in
diagram

IS Equation
Y= AD=C+I+G
Y = 0.8(1-0.25)Y +900 -50i + 800
Y =0.6Y+1700 -50i
0.4Y = 1700 -50i
Y = 4250 125i IS Equation

LM Equation

Equilibrium Income and Interest rate

IS = LM
4250 - 125i = 2000 + 250i
2250 = 375i
i=6 Interest rate
Y = 4250 - 125*6
Y = 4250 - 750
Y = 3500 . Income

IS-LM Diagram
i
125

IS

LM
6
0
2,000

3,500

4,250

Multiplier and Fiscal Policy

=(1/[1 - c + ct])
= 1/ [1-0.8 +0.8(0.25)]
= 1/ (1-0.8 +0.2)
= 2.5

Assume that government purchases increase by 300.

The IS-curve shifts parallel to the right by
= (2.5)(300) = 750.
Therefore, the equation of the new IS-curve is: Y = 5000 - 125i.

Problem
Assume the following IS-LM model
expenditure sector:
Sp
C
YD
TA

= C + I + G + NX
= 100 + (4/5)YD
= Y - TA
= (1/4)Y

I = 300 - 20i
G = 120
NX = -20

money sector:
M = 700
P =2
md = (1/3)Y + 200 - 10i

a.
Derive the equilibrium values of consumption (C) and money demand (md).
b.
How much investment (I) will be crowded out if the government increases its
purchases by G = 160 and nominal money supply (M) remains unchanged?

Solution
Sp = 100 + (4/5)[Y - (1/4)Y] + 300 - 20i + 120 - 20
From Y = Sp ==> Y = 500 + (3/5)Y - 20i ==> (2/5)Y = 500 - 20i
==> Y = (2.5)(500 - 20i) ==> Y = 1,250 - 50i IS-curve

From M/P = md ==> 700/2 = (1/3)Y + 200 - 10i ==> (1/3)Y = 150 + 10i
==> Y = 3(150 + 10i) ==> Y = 450 + 30i

LM-curve

IS = LM ==> 1,250 - 50i = 450 + 30i ==> 800 = 80i ==> i = 10

Y = 750 , C = 550,

M/P = 700/2 = 350 = md,

Check: md = (1/3)750 + 200 - 10*10 = 350

New Equilibrium Income and Interest rate

IS' = LM
5000 - 125i = 2000 + 250i
375i = 3000
i=8
Y = 2000 + 250*8
Y = 4,000
==> Y = 500

Policy Mix

Fiscal Policy- Government Expenditure and Taxes

Monetary policy- interest rates, Money Supply

3 Policy Options
To reach full employment output, Y*, for an
economy that is initially at point E, with
unemployment
3 Policy Options:
Fiscal policy expansion, moving to point E1,
with higher income and higher interest
rates
Monetary policy expansion, resulting in full
employment with lower interest rates at
point E2
A mix of fiscal expansion and
accommodating monetary policy resulting
in an intermediate position

Option 1: Expansionary FP
estment spending.
Increase in government
expenditures crowds out
investment spending through
rise in interest rates.
Income increases to Y0 instead
of Y

Crowding out phenomenon is associated with expansionary FP.

Option 2: Expansionary Monetary Policy

At the initial equilibrium, E, the
increase in money supply creates an
excess supply of money.
People tend to demand more bonds
till yields decrease at point E1
Decline in interest rate increases AD
and output expands till final position
is reached at Y.

Extreme case of Liquidity Trap associated with option 2

Liquidity trap occurs when
the LM curve is horizontal
changes in the quantity
of money do not shift it.
Monetary policy has no
impact on either the
interest rate or the level of
income monetary policy
is ineffective.

Policy 3 Mix of FP and MP

A policy mix of both
FP and MP can
achieve the goal of
holding interest rate
constant while
increasing output.

US Financial Crisis as explained by IS-LM

Interest rate i

The current liquidity trap ?

1. The subprime-based financial crisis

has frozen credit markets as well as
depressed consumption. This has
caused a large fall in investment,
shifting IS to the left

LM

LM

2. The central bank have responded by

injecting large amounts of liquidity in
the markets, and making credit easily
available(Quantitative easing). This
pushes LM to the right.

3. But these policies have had no

effect, and the rate of interest is
IS practically zero

i1
i2

IS
Y2

Y1

IS

3. The only way out is a large fiscal

policy push.

Income, Output Y

Lags in Policy
Inside Lag is the amount of time it takes for a government or
a central bank to respond to a shock in the economy. It is the
delay in implementation of a fiscal policy or monetary policy.
Outside Lag once a policy is implemented, its effects are
spread over a period of time.
Reaction uncertainties intended and unintended outcomes
associated with policy implementation.