The IS/LM Model, Part B

the IS curve (continued)

shifts of the IS curve

• 1. expected future output

  2. government spending

  3. expected future MPK

  4. corporate taxes

  5. wealth

  6. taxes

money

Money is a

• 1. medium of exchange

  2. store of value

  3. unit of account

Assume that the money supply is perfectly controlled by the central bank.

determinants of asset demand

• • expected return - rate of increase in its value

  • risk - chance that actual returns will be different from the expected return

  • liquidity - how quickly and easily it can be exchanged for goods, services, or other assets

The demand for money is determined by people's need to tradeoff liquidity against the cost of a lower return. Money demand depends on (a) the price level, (b) real income, (c) and interest rates. Assume that the nominal interest rate on money is zero, then the real money demand function can be written as MD/p = L(Y,I)

asset market equilibrium

If we assume that all assets can be grouped into two categories, money and nonmoney assets, asset market equilibrium simply requires that money supply equals money demand (MD = MS.

the LM curve

Point A is a point of asset market equilibrium when r=r1 and Y=Y1. Let Y increase to Y2. The money demand curve shifts up. Now, at r1, there is an excess demand for money. So, the interest rate rises. The new asset market equilibrium occurs at point C when r = r2 and Y = Y2.

The LM curve traces out those combinations of r and Y for which the asset market is in equilibrium, holding everything else constant.

shifts of the LM curve

• 1. nominal money supply

  2. price level

  3. interest rate on money

  4. expected rate of inflation

  5. payment technologies

complete IS/LM model

monetary policy in the IS/LM model

An increase in the nominal money supply causes a downward shift of the LM curve.

Assume that the economy moves to point F. Then, the labor market is no longer in equilibrium. Point F gives us aggregate demand. Since AD > Y*, firms raise prices causing the price level to rise. The LM curve shifts back up to the left until AD = Y* at point E.

• • economy is brought into equilibrium by adjustment of the price level (speed of adjustment is a matter of dispute)

  • money is neutral - had no effect on the real variables r, Y, and the level of employment

fiscal policy in the IS/LM model

An increase in government spending shifts the IS curve up to the right.

AD > Y*, so the price level rises. The LM curve shifts up to the left to restore equilibrium.

supply shocks