The is lm model and macroeconomic policy. IS-LM model and options for state economic policy
The classics and early neoclassicists did not see the problem in converting savings into investments, and they also believed that money only served to service transactions in goods and services. Therefore, these aspects are not reflected in the model AD - AS, which focuses on balance aggregate demand and suggestions.
At the same time, these aspects were clear and important for Keynes and his followers. Therefore, to include them in the general equilibrium picture, the English Keynesian John Hicks(1904-1989) suggested model IS – LM. In it IS means "investment - savings" (eng. investment, savings), a LM - "liquidity is money", more precisely, the demand for liquidity and the supply of money (eng. liquidity, money). An American also took part in the development of this diagram, which combined the equilibrium in the real and monetary sectors of the economy. Alvin Hansen(1887-1975) and therefore it is often called model, Hicks diagram – Hansen,
The first part of the model (IS) is designed to reflect the conditions of equilibrium in the market for goods (in the macroeconomic sense, i.e. the market for all goods), the second (LM) - on the market Money... Both markets are interconnected: changes in the market for goods cause certain shifts in the money market, and vice versa. The model somewhat simplifies the picture: a short period is assumed, prices and money supply remain unchanged, equilibrium in the commodity market is achieved under the condition S = I, and on the money market - on condition L = M.
In fig. 2.3, a curve IS depicts the ratio interest rate (G) and the level of national income ( Y ), which ensures equilibrium in the commodity market. Savings ( S ) and investments ( I ) depend on the level of income and the interest rate. Curve IS has a negative slope because investment is inversely related to the rate of interest, i.e. with a decrease in the percentage, investments will grow. Accordingly, income will increase ( Y ) and savings will grow ( S ), and to stimulate the transformation S v I the interest rate should continue to decline. Thus, investment is a function of the interest rate, savings is a function of national income, and the equilibrium of savings and investment is achieved with different combinations of the interest rate and the level of national income.
Rice. 2.3. CurvesIS (a ) andLM (b)
Curve LM (fig. 2.3, b) expresses the balance of supply and demand of funds in the money market. Economic agents' demand for cash and settlement accounts (liquidity) grows as income increases ( Y ), but at the same time the interest rate rises ( r ), i.e. money rises in price due to the increasing demand for them. At high rate percent, economic agents will prefer not to cash liquidity, a bank deposits and securities... This "folds" the curve. LM up. If the rate of interest falls, then the demand for liquidity rises. Thus, the equilibrium in the money market ( L = M) also achieved with different combinations of the interest rate and the level of national income.
Equilibrium in each of the two markets - the market for goods and the market for money - is established not autonomously, but interconnected. Changes in one of the markets invariably entail corresponding shifts in the other. Intersection point IS and LM satisfies the double equilibrium condition: first, the equilibrium of savings (5) and investment (I); second, the equilibrium of demand for cash ( L ) and their proposals ( M ). "Double" equilibrium is established at the point E 0 when IS crosses over LM (fig. 2.4).
Rice. 2.4.
Let's say the investment prospects are improving and the interest rate remains the same. Then entrepreneurs will expand capital investment in the production of national income. As a result, due to the multiplier effect, the national income will increase. As income increases, feedback will work. There will be a shortage of funds in the money market, and the balance in this market will be disturbed. Demand for participants will increase economic activity for money. As a result, the interest rate will rise. The double balance point will be E 1.
The process of mutual influence of the two markets does not end there. Higher rate of interest will "slow down" investment activity... Now equilibrium is at the point E 2 at the intersection of curves IS 1 and LM 1.
So, the equilibrium in the markets for goods and money is determined simultaneously by the rate of interest (r) and the level of national income ( Y ). For example, the equality between saving and investment can be expressed as follows: S (Y ) = I (f), and the equality between liquidity and money as L (Y) = M (r). In this case, the balance of regulatory instruments ( r and Y ) in both markets is formed interconnectedly and simultaneously. Upon completion of the process of interaction between the two markets, a new level is established r and Y .
Model IS – LM received the recognition of Keynes and became very popular. This model means concretizing the Keynesian interpretation of functional relationships in the commodity and money markets. It helps to represent functional dependencies in these markets and the impact economic policy on the economy. Interestingly, the Hicks-Hansen model is used by supporters of both neo-Keynesian and neoclassical directions. Thereby a neoclassical synthesis is achieved.
The conclusion from the model can be as follows: if the supply of money decreases, then the conditions of the loan are tightened, the interest rate rises.
As a result, the demand for money will decrease slightly. Part of the money will be used to purchase more profitable assets. The balance of demand for money and their supply will be violated, then it will be established at a new point. The interest rate here will be higher, and less money in the sphere of circulation. Under these conditions, the central bank will adjust its policy: the money supply will increase, the interest rate will decrease, i.e. the process will go in the opposite direction.
conclusions
- 1. General equilibrium is a state of the economy in which the output is sold and the demand is satisfied. It presupposes that the available labor force and production capacities are used in full, the disturbed proportions are constantly restored. Economic equilibrium is the coordinated, equilibrium development of all markets: goods and services, labor, money, capital, securities. It is achieved in the course of interaction and mutual adaptation of all spheres, sectors, factors of production.
- 2. The theory of general market equilibrium was developed by the economist and mathematician Leon Walras, who argued that every market economy tends to equilibrium in the form of a trend. The main tool for realizing interdependence and achieving mutually agreed proportions is exchange, as shown by Alfred Marshall. Following them, John Hicks, Alvin Hansen and other theorists formulated the conditions of equilibrium, determined the methods of achieving equilibrium in the economy.
- 3. John Keynes is considered the founder of the methodology of macroeconomic analysis. It was he who introduced into practice the functional analysis of macroindicators, showed the limitations of the classical theory of general equilibrium. Models of Keynes and his followers, including models AD – AS, IS – LM, help to understand the interconnectedness of the main macro indicators, to present a picture of the general market equilibrium in dynamics.
Partial equilibrium
General equilibrium
Hysteresis
Aggregate demand
Aggregate supply
Walras model
Walras's law
Model AD – AS
Model IS – LM (model, Hicks - Hansen diagram)
Model IS - LM (investment - savings, liquidity preference - money) - a model of commodity-money equilibrium, allowing to identify economic factors that determine the aggregate demand function. The model allows you to find such combinations of market rate% (R) and income (Y), when cat.
At the same time, equilibrium is achieved in the commodity and money markets.
IS - shows the set of combinations of interest rates and levels of national income and output, at which the commodity market is in equilibrium and the condition S = Iplan is satisfied.
LM - shows the many combinations of interest rates and income levels at which the money market is in equilibrium.
(Equilibrium of commodity and money market)
A - equilibrium only in the commodity market, but not in the money market. ADAD /
There is only one point where that and that market is in equilibrium.
The IS - LM model is analyzed for 2 time periods.
In the short run, the model is with fixed prices.
- in the long run, the economy is in a state of full employment, and the price level is mobile, therefore, in the long run IS - LM with flexible prices.
IS - LM Analysis Prerequisites
In the short term, the price level is fixed, hence the nominal and real values all variables are the same.
Aggregate supply or output is perfectly elastic and capable of satisfying any value of aggregate demand.
income (Y), consumption (C), investment (I), net exports (Xn) are endogenous (internal) variables and are determined within the model.
government spending (G), money supply (MS), taxes (T), are exogenous quantities and are set within the model.
Equilibrium.
1. Neither the IS curve nor the LM curve determine by themselves the value of the equilibrium income (Ye) and the value of the equilibrium rate% (Re). Equilibrium in the economy is determined jointly by the curves IS and LM, including their intersections. (fig. a)
2. The value of the equilibrium income Ye (a), corresponding to the simultaneous equilibrium of the commodity and money market (and hence the RZB, ie the financial market as a whole), Keynes called the “value of effective demand”.
3. The intersection of the curves IS and LM divides the plane into 4 areas (Fig. B), in each of the cat. - imbalance.
In areas I and II, there is an excess supply of money, since they are above the LM curve
In the region. III and IV - redundant. demand for money, because they are below LM.
In the region. I and IV are redundant. offer T&U, tk. they are higher than IS.
In the region. II and III - redundant. demand for T&U.
4. Directions of ek-ki adaptation and movement to balance are shown by arrows. If on the commodity market, it is redundant. supply of goods, then the stocks of firms will increase, and the value of output (income) Y will decrease (horizontal arrows to the left in areas I and IV towards the IS curve.
5. Faster - restoration of equilibrium in the money market, because for this it is enough to change the structure of portfolio analyzes, which does not require a significant investment of time; it takes more time to change the value of the output. (in the lecture there is still a lot of garbage with graphs, which Arefiev refers to this point, but it seems to me the main thing here, and we don't need any other politicians there))
More on topic 24. Macroeconomic equilibrium in the IS - LM model and the mechanism for its establishment .:
- 44. Equilibrium in macroeconomic models and its types. General and partial equilibrium in the economy.
- 1.3.3. Market equilibrium and special mechanisms for its establishment for various segments of the residential real estate market
- Mechanism for establishing market equilibrium at the micro level
- 10. Money market. Demand for money. Money supply. Equilibrium of the money market and the mechanism for its establishment. Equilibrium interest rate and equilibrium money supply.
Topic 14. Model IS-LM and options for the economic policy of the state
The commodity and money markets are interconnected. This allows you to determine the conditions under which a simultaneous equilibrium occurs in both markets. In the model AD - AS and models Keynesian cross the market interest rate is an external (exogenous) variable and is set in the money market relatively independently of the equilibrium of the commodity market. The famous English scientist J. Hicks developed on the basis of Keynesian theory a standard model of double market equilibrium, called the "IS-LM model". The main purpose of analyzing the economy using the model IS-LM is the unification of the commodity and money markets in unified system... As a result, the market interest rate turns into an internal (endogenous) variable, and its equilibrium value reflects the dynamics of economic processes taking place not only in the money, but also in the commodity markets. The general equilibrium in the market is investigated using the IS - LM curves apparatus. The combined analysis of the IS and LM curves constitutes in essence a complete Keynesian model considering the markets for goods and money.
The IS (Investment-Saving) curve characterizes the equilibrium in the commodity sector of the economy (see Fig. 11.11). This curve connects many points, which are combinations of interest rate i and level of real income Y, at which the market for goods is in equilibrium.
LM curve (Liquidity Preference - Money Supply) is a graphical interpretation of the relationship between the rate of interest and national income in equilibrium in money markets. In the LM acronym, L stands for liquidity preference, the Keynesian term for MD, and M stands for money. When equilibrium is achieved in the money market, equilibrium is simultaneously established in the securities market. Thus, to determine the conditions for achieving joint equilibrium in the markets of goods, money and capital, it is necessary to combine these 2 curves.
Model IS-LM - a model of commodity-money equilibrium, which makes it possible to identify economic forces determining the aggregate demand function. The model allows you to find such combinations of the market interest rate i and income Y , at which equilibrium is simultaneously achieved in the commodity and money markets. Therefore, the IS-LM model is a concretization of the AD-AS model.
To build an IS-LM model, it is necessary to determine the parameters connecting the commodity and money markets. The main parameter of the commodity market is the real volume of national production. It is known that it determines the demand for money for transactions and, therefore, the general demand for money and the interest rate at which equilibrium is achieved in the money market. In turn, the level of interest rates affects the volume of investments, which are an element of total costs. Thus, monetary and commodity markets are interconnected through national income Y, investment I, interest rate i.
Let us consider these relationships graphically, first on the commodity (IS curve), and then on the money markets (LM curve). The price level will be considered constant, and the economy - closed.
CurveIS... Topic 11 showed the derivation of the IS curve using the savings and investment functions (Figure 11.11). Similar conclusions can be drawn using the Keynesian cross model (Figure 14.1).
The investment graph (Fig. 14.1, a) shows that low interest rates correspond to a high level of investment. At the level of the interest rate i1, the volume of planned investments will be I1. Accordingly, the total expenditures AE (Fig. 14.1, b) are shown by the line C + I1 (i1) + G, which, intersecting with the bisector, determines the equilibrium point E1 and the equilibrium volume of national income Y1. Thus, at the interest rate i1, the national income Y1 will be in equilibrium. These parameters will define point A (Fig. 14.1, c). When the interest rate decreases from i1 to i2, investments increase from I1 to I2 (Figure 14.1, a), the total spending curve will shift upward to position C + I2 (i2) + G. This, in turn, raises the equilibrium level of national income from Y1 to Y2 (Figure 14.1, b). These parameters will determine point B. If you continuously change the interest rate and for each find the corresponding values of national income, then on the graph we will get the IS curve (Fig. 14.1, c).
a) Investment function c) CurveIS
I (interest rate) i (interest rate)
I (i) IS
I2 ® I1 I (investment) Y1 ® Y2 Y (income,
DI issue)
b) Keynesian cross
AE (cumulative Y = E
costs) С + I2 (i2) + G
DI
Y2 ® Y1 Y (income,
Rice. 14.1. Curve plottingISfrom Keynesian cross
On the rice. 14.1 , a depicts the investment function: reducing the interest rate from i 1 before i 2 increases planned investments with I1 before I 2 .
On the rice.14.1 , v Keynes's cross is depicted: an increase in planned investments with I1 before I 2 increases income from Y1 before Y 2 ..
On the rice.14.1 , With curve shown IS : the lower the interest rate, the higher the income level.
It should be noted that on rice.14.1 curve IS built on the basis of a number of prerequisites and assumptions about the levels of Ca, G, T and the shape of the graph I = I (i). Changes in any of these factors lead to a shift in the curveIS .
On the rice. 14.2 another way of plotting a curve is shown IS .
IY i (bid percent) I
I Y
(investments) I2 I1 Y1 ® Y2 (income, release)
III S (saving) S (Y) II
Rice. 14.2. Alternative graphical plotting of a curveIS
In the quadrant II presents a graph of the savings function S (Y), showing the growth of savings as a function of Y. In the quadrant III the graph I = S is presented (a line at an angle of 45 ° to the coordinate axes I and S). In the quadrant IY the graph of the investment function I = I (i) is presented, showing the growth of investment as a function inverse to the level of the interest rate i. Based on this data in the quadrant I we find the set of equilibrium combinations of Y and i, that is, the curve IS: IS1 (Y1, i1) and IS2 (Y2, i2).
Curve interpretationISusing the borrowed funds market model
The identity of the national income accounts can be written as
Y- C- G= I,
S= I.
The left side of this equation represents national savings S: the sum of private savings Y- T- C and government savings T- G, and the right side is investment I. National savings represent the supply of borrowed funds, and investment is the demand for them.
To show how the IS curve can be constructed based on the borrowed funds market model, we replace C with the consumption function and I with the investment function:
Y- C(Y- T)- G = I(i).
The left side of the equation states that the supply of borrowed funds is dependent on income and fiscal policy; right - what is the demand for borrowed funds depends on the interest rate. The interest rate is changed so as to balance the demand for the supply of borrowed funds.
As you can see in Figure 14.3, we can interpret the IS curve as a curve showing the interest rate that balances the market for leveraged funds at any given income level. When income rises from Y1 to Y2, national savings, equal Y-C-G, increase. (Consumption grows less than income, since MPC<1). Возросшее предложение заемных средств снижает ставку процента с i1 before i2 ... The IS curve summarizes this relationship: higher income means higher savings, which in turn means a lower equilibrium interest rate. For this reason, the IS curve has a negative slope.
S(Y1 ) S(Y2 )
i i
i2 I (r) i2 IS
I, S Y1 Y2 Y
a) Credit market. b) CurveIS
Rice. 14.3. Curve interpretationISusing the borrowed funds market model
Rice. 14.3, a shows that an increase in income from Y1 to Y2 increases savings and decreases the interest rate that balances the supply and demand of borrowed funds. Rice. 14.3, b reflects the negative relationship between income and interest rates.
This alternative interpretation of the IS curve also explains why changes in fiscal policy shift the IS curve. Higher government spending or tax cuts reduce national savings for a given income level. A decrease in the supply of resources in the market for borrowed funds increases the interest rate, which ensures equilibrium. Since the interest rate is now higher for a given income level, the IS curve shifts upward in response to a stimulating change in fiscal policy.
LM curve... The volume of national income Y1 determines the demand for money for transactions and, accordingly, the aggregate demand for money MD1. If the money supply is constant and equal to MS, then the money market will be in equilibrium at point E1 (Figure 14.4, a). Consequently, with national income Y1, the money market will be in equilibrium if the interest rate is i1. Suppose the national income has increased from Y1 to Y2. Accordingly, the demand for money for transactions and the aggregate demand increased from MD1 to MD2 (Fig. 14.4, a). With national income Y2, the money market will be in equilibrium when the interest rate is equal to i2. Changing continuously the volume of national income, you can determine the set of interest rates at which the money market will be in equilibrium and build the LM curve (Figure 14.4, b). Each point of the LM curve shows a combination of i and Y, at which the money market is in equilibrium. Thus, the LM curve shows the relationship between the interest rate and the level of income that arises in the real money market. The higher the income level, the higher the demand for money and, therefore, the higher the equilibrium interest rate. Therefore, the LM curve has a positive slope, which is explained by the direct relationship between i and Y.
a) b)
Rice. 14.4. Curve plottingISwith a constant supply of money
The LM curve is constructed on the assumption that the money supply is constant and equal to MS, since it is determined exogenously.
1) Y= C+ l+ G - basic macroeconomic identity.
2) C= Ca+ MPC´ (Y- T) is the consumption function, where T= Ta+ tY.
3) l= e- dR - investment function.
4) M / P = kY - hR- money demand function.
These two equations contain three variables of interest to us: Y, P, i.
Internal variables of the model: Y (income), WITH (consumption), I (investment), i (interest rate).
External variables of the model:G (government spending), MS (money offer), t (tax rate).
Y = C(Y- T)+ I(i)+ G - curve equation IS
M/ P = L(i, Y) - curve equation LM
Fiscal and Monetary and Policy in the Model IS - LM with fixed prices and its impact on aggregate demand
Now let us analyze the impact of different macroeconomic policy options on aggregate demand using the IS-LM graphical apparatus and consider how each planned policy change affects the equilibrium level Y. The IS and LM curves can change their position under the influence of various factors (excluding i and Y ). So, changes in consumption, government purchases, net taxes lead to shifts in the IS curve. Changes in the demand for money, money supply shift the LM curve.
Of greatest interest are the shifts in the curves that occur with changes in government purchases of goods and services, taxes and money supply, because they are objects of regulation in fiscal and monetary policy.
Fiscal (fiscal) policy The IS curve is drawn for a specific fiscal policy, that is, the IS curve assumes that G and T are fixed. When the fiscal policy changes, the IS curve shifts. With a stimulating fiscal policy and baseline price levels, interest rates and aggregate demand increase, leading to a shift to the right of the IS curve. The distribution of the effect of this increase in demand between the growth in output and prices depends on the slope of the IS and LM curves.
1. State purchases of goods and services. Consider a shift in the IS curve caused by an increase in government purchases of goods and services. Suppose that initially the general equilibrium in the markets for goods and money was achieved at point E1 at the interest rate i1 and national income Y1 (Figure 14.8). Let's say the economic situation in the country demanded an increase government spending... They led to an increase in total expenditures, which leads to an increase in national production and national income (it should be borne in mind that government spending has a multiplier effect). This causes the IS1 curve to shift to the IS2 position. But a growing national income increases the aggregate demand for money, which begins to exceed the supply of money, which leads to an increase in the interest rate to i2. In the commodity market, an increase in total spending prompts entrepreneurs to increase their investment accordingly. However, the growth of the interest rate begins to restrain this process, forcing entrepreneurs to reduce the investment growth planned at the interest rate i1. As a result, the national income will rise to Y2 rather than Y3. In this case, a new equilibrium position in the markets for goods and money will be achieved at point E2 with values of Y2, i2.
When the government increases purchases of goods and services at DG in order to stimulate aggregate demand, the IS curve shifts upward to the right. There is an increase in Y not by DY = Y3 - Y1, but by Y2 - Y1, i.e., to a lesser extent than expected: an increase in the interest rate reduces the multiplier effect of government spending.
The increase in the interest rate is associated with the crowding out effect.
Thus, the IS-LM model shows that an increase in government spending causes both an increase in the volume of national income from Y1 to Y2, and an increase in the interest rate from i1 to i2. The growth in government spending led to an increase in aggregate demand, but by a smaller amount than follows from a simple Keynes multiplier:
DY = Y3 - Y1 = kG´DG, kG = 1 / (1– MPC). However, the national income will increase to Y2, not Y3.
Figure 14.8 Shift of the IS curve caused by the growth of government procurement of goods and services and the crowding-out effect
One of the consequences of the increase in budget spending is manifested in the rise in interest rates, leading to a reduction in investment and private consumption. This impact of rising interest rates on consumption and investment due to increased government spending has been termed displacement effect That is, an increase in government spending partially crowds out private investment. Since the increase in government spending is financed by government loans in the money and capital markets, the demand for money increases and, consequently, the interest rate rises. The crowding-out effect reduces the effectiveness of expansionary (stimulating) fiscal policy. It is to him that monetarists refer, arguing that fiscal policy is not effective enough and priority in macroeconomic regulation should be given to monetary policy.
However, the crowding-out effect is only partially working, and aggregate demand is growing, despite the decline in private spending due to higher interest rates. Conversely, a reduction in government purchases of goods and services on DG leads to a fall in Y, while the interest rate falls.
2. Taxes.
Tax cuts have the same effect as increases in government spending: the IS curve shifts to the right by DY = kT DT, kT = - MPC / (1– MPC).
The interest rate is increasing due to the general growth in demand. That is, tax cuts increase aggregate demand and, therefore, shift the IS curve to the right.
Figure 14.9. IS Curve Shift Caused by Tax Cuts
An increase in taxes leads to the opposite result: the interest rate falls Þ the state collects additional money not through loans, but receives it through taxes; at the same time, the demand in the market falls.
This situation is typical for Russia. High taxes stifle production.
Aggregate demand and taxes are inversely related: tax cuts increase aggregate demand, and vice versa.
Money-credit policy . Consider the displacement of the LM curve under the influence of changes in the money supply. Suppose that the supply of money has increased and begins to exceed demand, which will lead to a decrease in the interest rate. A new equilibrium position in the money market will be achieved at a lower interest rate i2, which will cause a corresponding shift of the LM curve to the right, to the LM2 position (Figure 14.10).
Increased money supply
An increase in the money supply shifts the LM curve downward to the right, as a result, the interest rate falls from i1 to i2, the GNP rises from Y1 to Y2. The IS-LM model shows that an increase in M leads to a shift to the right of the LM curve.
Fig. 14.10 Curve shiftLMcaused by increased money supply
Conversely, a policy of restraint leads to an increase in the interest rate; the LM curve moves to the left and up, the GNP is reduced.
Consequently, in the IS-LM model, changes in the money supply affect the equilibrium level of GNP (national income).
Combinations of tax and monetary policy
MD = const
IS is shifted left and down, which causes a fall in interest rates and a reduction in output.
Fig. 14.11, a. Increasing taxes with a constant money supply
r = const
The Central Bank keeps the interest rate at a constant level.
Both curves are shifted: IS - left-down, LM - left-up, respectively, the equilibrium point moves from E1 to E2.
The issue is reduced from Y1 to Y2.
The state suppresses investment activity.
Fig. 14.11, b. Increase in taxes at a constant interest rate
The Central Bank maintains the volume of production at a constant level, increasing the supply of money.
This is the case when a decrease in the interest rate is offset by a tax increase. As a result, the output level remains the same.
Fig. 14.11, c. An increase in taxes with an increase in the supply of money and a decrease in the interest rate.
Some special cases of model analysisIS-LM.
The three best-known cases of IS-LM model analysis have greatly influenced the debate over basic concepts of macroeconomics.
i
i2
In the first case, shown in Figure 14.12, LM is vertical. In this case, the demand for money is insensitive to changes in the interest rate, that is, the velocity of money circulation is constant. Then the equation of money demand takes the form: M / P = L (Y). In this case, as can be seen in the graph, fiscal expansion does not affect aggregate demand. Moreover, the shift of IS to the right leads exclusively to an increase in the interest rate, without affecting in any way the demand for manufactured products, i.e., Y = Y0. In other words, there is only one level of demand Y0 at which the money market is in equilibrium.
It should be noted that fiscal expansion in the case of a vertical LM leads to a crowding-out effect, as opposed to partial crowding out when the LM has a normal positive slope. While the magnitude of aggregate demand remains unchanged, its structure is fundamentally changing. The increase in government spending is now equal to the total decrease in private consumption and investment.
In the IS-LM model, changes in the money supply affect the equilibrium level of the national income. However, Keynes' followers argued that this influence is sometimes insignificant, for example, at interest rates close to minimum. Under these conditions, the demand for money is infinitely elastic with respect to the interest rate, that is, equilibrium in the money market is achieved at a single value of the interest rate. The extremely low interest rate leads to the fact that the population, banks are not willing to buy bonds, assuming that the opportunity cost of keeping money is very low, but prefer to accumulate money, whatever their supply. In this case, the money demand curve is parallel to the abscissa, which means that the LM curve is horizontal. Therefore, in this case, the change in the money supply does not change the real national income. This situation is called a liquid trap, as shown in Figure 14.13. It was cited by the early followers of Keynes when they argued the ineffectiveness of monetary policy. In such cases, fiscal policy has a large impact on aggregate demand, and monetary policy has no impact, since the interest rate is fixed and cannot decrease as a result of monetary expansion.
The third case arises when consumption and demand for investment are inelastic: this means that C and I are insensitive to the interest rate. In this case, the IS curve is vertical because it does not depend on changes in the interest rate. The situation when investments do not respond to changes in the interest rate is called an investment trap. Figure 14.14 shows that fiscal policy has a strong effect on aggregate demand, but monetary policy does not affect aggregate demand at all.
It should be noted that fiscal policy fully works, i.e., there is no crowding-out effect, both when the IS curve is vertical, and when the LM curve is horizontal. However, the reasons for this are different in each case. In the presence of a "liquid trap", the interest rate does not change, since equilibrium in the money market is achieved at a single level. Thus, fiscal expansion does not lead to an increase in the interest rate, and the crowding-out effect does not occur. In contrast, when the IS curve is vertical, interest rates rise, but private spending — consumption and investment — does not decrease in response to an increase in the interest rate.
IS-LMand modelAD-AS.
ModelIS- LMand curveAD
The AD curve reflects the relationship between the level of prices and income in the economy. This relationship is derived from the quantitative theory of money. With a constant volume of money supply, an increase in the price level leads to a decrease in income. An increase in the money supply shifts the AD curve to the right, and a decrease in the money supply shifts the AD curve to the left.
Now, to obtain the AD curve, we use not the quantitative theory of money, but the IS-LM model. First, the IS-LM model is needed to show that national income declines as the price level rises; and also to construct an aggregate demand curve that reflects this relationship, which has a negative slope. Second, it is necessary to investigate the causes of the shift in the AD curve.
Why does the AD curve have a negative slope? To answer this question, let's see what happens to the IS-LM model when the price level starts to change. Figure 14.15 illustrates the impact of changing price levels.
For a given supply of money M, a higher price level P decreases the real money supply M / P. A decrease in the money supply in real terms shifts the LM curve upward and leftward and decreases the equilibrium level of income, as shown in Fig. 14.15, a. Here we see that when the price level rises from P1 to P2, GNP falls from Y1 to Y2. When the LM curve shifts, a change in the price level will lead to a change in income values. The AD curve in Fig. 14.15, b reflects the inverse relationship between the level of national income and the level of prices, which is obtained using the IS-LM model.
i LM (P = P2) P
LM (P = P1)
P2
Y2Y1 Y Y2Y1 Y
Rice. 14.15, a. ModelIS- LM14.15, b. Aggregate demand curve
What can cause a shift in the AD curve? Since the AD curve summarizes the conclusions of the IS-LM model, shocks that shift the IS curve or the LM curve also cause the AD curve to shift. Monetary and fiscal incentives increase the income level in the IS-LM model and therefore move the AD curve to the right (Figure 14.16).
i LM 1 i LM
LM2
Y Y
R R
YY
a) b)
Rice. 14.16
a) Monetary incentive measures
b) Fiscal policy incentives
Likewise, monetary or fiscal policy constraints reduce the income level in the IS-LM model and therefore shift the AD curve to the left.
These results can be summarized as follows:
· IS- LMresulting from a change in the price level is a movement along the curveAD;
· change in income level in the modelIS- LMat a fixed price level, it is a shift of the entire curveAD.
Having determined the increase in AD, it is necessary to assess how it will be distributed between the increase in prices and the increase in output. This will depend on the portion of the AS curve. In the segment of the AS curve, an increase in AD will only affect the rise in prices; in the normal section, both output and prices will rise; in the Keynesian segment with a horizontal supply curve, an increase in demand will be fully reflected in an increase in output.
ModelIS- LMin the short and long term
The IS-LM model is derived to explain the functioning of the economy in the short run when the price level is fixed. However, the IS-LM model can also be used to describe the economy in the long run, when the price level changes, ensuring that the volume of output corresponds to the potential level of production in the economy. Using the IS-LM model to describe the long-term period, it is possible to show how the Keynesian model of national income differs from the classical model.
In fig. 14.17, a shows three curves that are necessary for a joint analysis of short-term and long-term equilibrium: the IS curve, the LM curve and the vertical l Iniya representing the potential production level Y. As always, the LM curve is drawn for a given price level P1. Short-term equilibrium in the economy is reached at point K, where the IS curve intersects the LM curve.
In fig. 14.17, c shows the same situation on the graph of aggregate demand and aggregate supply. At the P1 price level, the demand for goods and services is less than the potential output level. In other words, at the current price level, the demand for goods and services is insufficient to keep production at a level corresponding to its potential.
In these two graphs, you can explore the short-term equilibrium that the economy is in at any given moment in time, and the long-term equilibrium that the economy is striving for. Point K describes short-term equilibrium, since prices are assumed to be fixed at the P1 level. Ultimately, the low level of demand for goods and services causes prices to decline, which helps the economy to recover its potential GNP. When prices reach P2, the economy is at point C, the point of long-term equilibrium. The AD-AS graph shows that at point C the amount of demand for goods and services is equal to the potential volume of production. This position of long-term equilibrium is achieved on the IS-LM chart by shifting the LM curve: a fall in the price level increases the real stock of money and, therefore, shifts the LM curve downward.
Keynesian approach is to complement or "close" the model fixed price premise so that the third equation is P = P1
This prerequisite means that i and Y must change in such a way as to ensure the simultaneous solution of equations IS, LM.
The classic approach is that release reaches potential level, so that the third equation of the system will be _
Y = Y
This assumption means that in order to satisfy the equations IS, LM, parameters i and P. must change.
What is the most acceptable assumption? The answer depends on the time horizon adopted in the analysis. The classical premise describes the long-term period well. Therefore, our analysis of economic fluctuations is based on the assumption of a fixed price level.
Monetary Policy and Money Supply Curves MS,LM (model IS-LM), planned investmentsIand aggregate demand AD
(model AD - AS) in the long run
Let us now turn to an examination of the impact of expansionary monetary policy on the national economy in the long run.
In fig. 14.18, g point T2 - the point of short-term equilibrium of the economic system. However, the economic system cannot remain in this position indefinitely. When the economic equilibrium moved from point T1 to point T2, the level of prices for final goods and services increased. After some time, this increase in prices will entail an increase in the prices of factors of production (increase in cost prices). These changes in prices will lead to a shift of the aggregate supply curve AS up - to the left along the AD2 curve until it returns to the natural level of production at the equilibrium point T3 (Fig. 14.18, c).
At point T3 (Fig. 14.18, d), prices for final goods and services, as well as for factors of production, consistently increase in proportion to the growth of the money supply in circulation, due to the expansionary monetary policy. This rise in prices causes a further displacement of the demand curve for money MD in the money market (Fig. 14.18, a) along the money supply curve MS2 from position MD2 to position MD3. Equilibrium is established at point e3. This causes the interest rate to rise from i2 to i3.
With the new equilibrium position in the money market, in the IS-LM and AD-AS models and in the investment market in the long run, the real output and the interest rate have returned to their initial levels.
This result is known in economics as long run money neutrality.
Money is neutral in the sense that a one-time irreversible change in the amount of money in circulation causes only a proportional change in the price level in the long run, without affecting the real volume of production, real planned investments and the interest rate.
1. Dolan EJ et al. Money, banking and monetary policy. SPb .: "St. Petersburg Orchestra", 1994, p. 331
Mankiw N. Gregory Macroeconomics, p.381
The basis for constructing the IS curve is: 1) the model of total expenditures (the Keynesian Cross model), discussed in Chapter 12, which shows what determines income in the economy at a given level of planned expenditures (that is, proceeds from the assumption that the level of planned autonomous costs are fixed); 2) the function of the dependence of autonomous planned expenses on the interest rate.
Since the model includes a new endogenous variable - the interest rate - we will consider it in more detail. Interest rate and offline expenses. For savers, the interest rate acts as a reward for abstaining from consumption in the present at the expense of expected consumption in the future. For borrowers, the interest rate is the price of the borrowed funds used by investors to buy investment goods and by households to buy consumer durables. There are many specific types of interest rates in the economy, such as interest rates paid:
- banks for checking, savings and term accounts;
- on funds borrowed by the government (interest on government bonds),
- business (interest on commercial securities and corporate bonds),
- commercial banks to the central bank (discount rate),
- households (interest on mortgages, mortgages and consumer credit).
In economic theory, which identifies the basic, fundamental relationships and interdependencies in the economy, the differences between different types of interest rates are assumed to be insignificant and the market interest rate is understood as the average of all different rates.
The relationship between autonomous projected costs and the interest rate. Changes in the interest rate affect the following components of offline costs:
... investment costs. By borrowing money to buy investment goods, firms are trying to make a profit. Therefore, they invest in equipment and industrial structures (acquire real capital) as long as the rate of return on the additional unit of capital exceeds the cost of borrowed funds for the purchase of this additional unit, i.e. interest rate. Any increase in the interest rate reduces the efficiency of investment projects. Therefore, if the interest rate is so high (credit funds are expensive) that the expected rate of return is lower than this rate, the firm will refuse to implement such an investment project and the amount of investment costs will decrease. Consequently, the relationship between the amount of investment costs and the interest rate is reversed. The higher the interest rate, the less willing firms are to invest. The investment function can be written: I = I ( R) or, if the dependence is linear:
I = I- dR, where I is stand-alone investment, R is the interest rate, d is the coefficient reflecting the sensitivity of investment costs to the interest rate and showing how much the value of investment costs will change when the interest rate changes by one percentage point. The coefficient d> 0, and since there is a minus sign in front of it in the formula, the curve has a negative slope.
The aggregate investment demand curve (Fig. 1. (a)) reflects this inverse dependence of the value of demand for investment on the interest rate.
A shift in the curve of total investment costs occurs when the value of autonomous investments (I) changes: their increase shifts the curve to the right, and their reduction - to the left. As a rule, Keynesian representatives associate these changes with investor sentiment, pessimistic or optimistic assessment of the expected profitability of investment costs.The consequences of an increase in the level of autonomous investments are shown in Fig. 1. (b) by shifting curve I to the right to I '.
The slope of the curve of total investment costs is due to the value of the coefficient d; the higher it is, i.e. the more sensitive investments are to changes in the interest rate, the flatter curve I: even minor changes in the interest rate lead to significant changes in the value of investment demand.
... consumer spending. Similar to investors, households also use borrowed funds, especially when purchasing consumer durables. Consumers compare interest payments on a debt (consumer loan) with a desire to purchase a product (for example, a car or dishwasher) as soon as possible. High interest rates are forcing some consumers to delay buying until better times and offline consumer spending is on the decline. Thus, the relationship between aggregate autonomous consumer spending and the interest rate is reversed, and all reasoning and conclusions are similar to those made for investment spending (it is no coincidence that some economists suggest considering spending on consumer durables as investment spending by households). Thus, consumer spending depends not only on the level of disposable income, but also on the interest rate, and the consumption function can be represented by the formula: С = С (Y, T, t, R) or with linear dependence: С = WITH+ mpc (Y - T- tY) - aR, where WITH- autonomous consumer spending, Y - income, T - autonomous net taxes (Tx taxes minus Tr transfers), mpc - marginal propensity to consumption (0
... net export costs. The change in the interest rate also affects the value of net exports. The growth of the interest rate in the country increases the profitability of the invested capital and determines the inflow of capital from abroad. As a result, the demand for the national currency of a given country in foreign exchange markets is growing, and the national currency is becoming more expensive. This leads to the fact that the goods of a given country become relatively more expensive, and imported goods are relatively cheaper. The demand for national goods from foreigners falls, reducing exports, and the demand for foreign goods is growing, increasing imports. Net exports are shrinking, lowering total spending. Consequently, there is an inverse relationship between net exports and the interest rate.
Therefore, the export formula can be represented as: Xn = Xn ( Y, e) or with linear dependence: Xn = Ex - (Im+ mpm Y) - eR = Xn- mpm Y - eR,
where Ex- offline export; Im- offline import; Xn- autonomous net export; mpm - marginal propensity to import (0
Plotting the IS curve. Since the magnitude of the planned autonomous expenditures depends on the interest rate, and the total level of real output and real income depends on the magnitude of the autonomous planned expenditures, then if we combine these dependencies together, we can come to the conclusion that real income should depend on the interest rate. By plotting this relationship graphically, we get the IS curve. Let's plot the IS curve in two ways:
In fig. 2. (a) IS curve derived from Keynesian cross and investment function. At the interest rate R 1, the amount of investment costs is equal to I 1, which corresponds to the amount of planned costs Ер 1, at which the amount of total income (output) is equal to Y 1. When the interest rate decreases to R 2, the value of investment costs increases to I 2, therefore, on the Keynesian cross graph, the planned expenditure curve shifts up to Ep 2, which corresponds to the total income (output) Y 2. Thus, a higher rate of interest R 1 corresponds to a lower level of total output Y 1, and a lower rate of interest R 2 corresponds to a higher level of output Y 2. Moreover, in both cases, the commodity market is in equilibrium, i.e. expenses are equal to income (Ер 1 = Y 1 and Ер 2 = Y 2). This is what the IS curve reflects, each point of which shows paired combinations of the interest rate and the level of income, at which the commodity market is in equilibrium.
In fig. 2. (b) the IS curve is derived from the principle of equality of injections (investments) and withdrawals (savings) (which is the condition for the equilibrium of the commodity market), which follows from the basic macroeconomic identity:
C + I + G + Ex = C + S + T + Im
Subtracting consumer spending C from both sides of the equality, we get:
I + G + Ex = S + T + Im
On the right side of the equation, injections are expenses that increase the revenue stream, and on the left side, leakages are variables that reduce revenue. In an equilibrium economy, expenses are equal to income, and injections are equal to withdrawals. Injections are negatively dependent on the interest rate, and withdrawals are positively dependent on the level of income. Given these dependencies, you can write:
I (R) + G + Ex (R) = S (Y) + T (Y) + Im (Y)
In fig. 2. (b) 4 graphs are shown. Graph I shows the equilibrium condition for the commodity market - the equality of injections (represented by investments) and withdrawals (represented by savings), which graphically reflects the bisector of the angle (line at an angle of 45 o). Graph II shows a graph of the direct dependence of withdrawals on income. Graph III shows the inverse relationship between injections and interest rates. As a result, on the IV graph we get the IS curve. At the interest rate R 1, the amount of injections is I 1, which corresponds to the amount of withdrawals S 1, and this amount will be at the income level Y 1. Similarly, at the interest rate R 2, the amount of injections will be equal to I 2, at which the amount of withdrawals will be S 2, which corresponds to the level of income Y 2. Connecting the points obtained in the IV graph with a straight line, we get the IS curve.
The IS curve shows all possible combinations of interest rate (R) and real income (Y) levels at which the commodity market is in equilibrium, i.e. the demand for goods and services is equal to their supply, which occurs only when the income is equal to the planned expenditures, and the injections are equal to the withdrawals.
Points outside the IS curve. At any point outside the IS curve, the economy is in imbalance. For example, in point A (Fig. 2. (b)), which is above the IS curve, the amount of income is equal to Y 2, which corresponds to the amount of withdrawals S 2, and the interest rate is R 1, at which the amount of injections is equal to I 1. In this case, seizures exceed injections (S 2> I1), which means that income (output) in the product market exceeds expenses, i.e. the supply of goods exceeds the demand for goods. Consequently, at all points above the IS curve, there is an excess supply of goods (ESG).
In point B, which is below the IS curve, the amount of income is equal to Y 1, which corresponds to the amount of withdrawals S 1, and the interest rate is equal to R 2, which corresponds to the amount of injections I 2. Since I 2> S 1, this means that injections are larger than withdrawals, i.e. expenses exceed income (output), therefore, demand is greater than supply. Thus, at all points below the IS curve, there is excess demand for goods (EDG).
The slope of the IS curve. The IS curve has a negative slope because a higher level of interest rates causes a decrease in investment, consumer spending and spending on net exports, and therefore in aggregate demand (aggregate spending), which leads to more low level equilibrium income. Conversely, more low rate percent increases autonomous planned expenses, and a higher level of autonomous expenses increases income by k A times, where k A is the full multiplier (or super-multiplier) of expenses.
The most complete picture of the relationship between the level of income (Y), the interest rate (R) and the features of the IS curve is given by its algebraic analysis.
Algebraic analysis of the IS curve. Recall that the equilibrium level of income is established when the volume of output (Y) is equal to the total planned expenditures (E = C + I + G + Xn). We assume that the consumption function, investment function and net export function are linear and depend on the interest rate:
C = WITH+ mpc (Y - T- tY) - aR
I = I - dR
Xn = Ex - (Im+ mpmY) - eR = Xn- mpmY - eR
Equilibrium income is equal to:
Y = (C - mpcT + I + G + Xn - bR) / (1 - mpc (1 - t) + mpm)
where b = (a + d + e) and is the coefficient of sensitivity of autonomous expenditures to the interest rate, showing how much autonomous expenditures will change when the interest rate changes by one percentage point.
Since C - mpcT + I + G + Xn = A (sum of autonomous expenses) and = k A (full multiplier of expenses), the equation of the IS curve can be represented: Y = k A (A - bR) or for the interest rate as: R = A / b - (1 / k A b) Y
Since the coefficient b> 0 and has a minus sign in front of it, the IS curve has a negative slope. Shifts of the IS curve. The shifts in the IS curve are due to changes in any of the offline cost components (C, I, G, or Xn) and offline net taxes (Tx or Tr). Anything that increases autonomous spending (the optimism of entrepreneurs and consumers, which increases their desire to increase spending at any interest rate, which leads to an increase in consumer and investment spending; an increase in government spending; a decrease in autonomous (lump-sum) taxes; an increase in transfer payments; an increase in net exports) , shifts the IS curve to the right. If the autonomous costs for some reason decrease, the IS curve shifts to the left. The shift of the curve in both cases is parallel and occurs at a distance equal to k A ΔА (since ΔY = k A ΔА), i.e. the shift distance at a constant interest rate is determined by the magnitude of the change in autonomous expenditures and the magnitude of the expenditure multiplier. The more the autonomous costs change and / or the greater the multiplier value, the greater the distance the curve shifts.
The slope of the IS curve. The slope of the IS curve is 1 / (k A b) or MLR / b, where MLR is the maximum seizure rate (recall that MLR = 1 - mpc (1 - t) + mpm = mps (1 - t) + t + mpm, i.e. the marginal rate of withdrawals is the reciprocal of the multiplier of expenditures, MLR = 1 / k A). Thus, the slope of the IS curve is determined by: 1) the sensitivity of autonomous expenditures to the interest rate (b), 2) the value of the multiplier (kA), which depends on the marginal propensity to consume (mpc), the tax rate (t) and the marginal propensity to import ( mpm).
The slope of the IS curve decreases (it turns clockwise and becomes flatter). The IS curve will be flatter:
... the sensitivity of autonomous expenditures to the interest rate (b) is high, which means that even a small change in the interest rate leads to a significant change in autonomous expenditures and, therefore, income;
... the expense multiplier (k A) is large, and the marginal withdrawal rate (MLR) is small, which is possible if: a) the marginal propensity to consume is high; b) the marginal tax rate is low; c) the marginal propensity to import is small. If the multiplier is large, it means that even a minor change in autonomous spending will lead to a large multiplicative change in income. (Note that the magnitude of the multiplier determines both the slope and the magnitude of the shift of the IS curve).
Thus, increasing b and mpc and decreasing t and mpm decrease the slope of IS.
The slope of the IS curve increases (it turns counterclockwise and becomes steeper) as the value of b and / or k A decreases.
The IS curve, however, does not determine either a specific value of the income level Y, nor a single value of the equilibrium interest rate R, it only reflects all possible combinations of Y and R, in which the market for goods and services is in equilibrium. Therefore, in order to determine their values, one more equation with the same variables is needed. To do this, you should turn to the money market.
LM curve
Equilibrium in the money market is determined by the curve LM (liquidity preference - money supply), which shows all possible ratios of Y and R, in which the demand for money is equal to the supply of money. In this case, money is usually understood as the monetary aggregate M1, which includes cash and funds on current accounts (demand deposits - checking accounts or demand accounts), which can be easily converted into cash at any time.
The LM curve is based on Keynesian theory liquidity preferences, which explains how the supply and demand ratio of real money balances determines the interest rate. Real cash holdings are nominal stocks adjusted for price level changes and equal to M / R.
In accordance with the theory of liquidity preference, the supply of real money (M / R) S is fixed and determined the central bank controlling the amount of cash C and reserves R, i.e. monetary base (H - high powered money; H = C + R). Since the money supply is an exogenous quantity and does not depend on the interest rate, it can be graphically represented by a vertical curve.
The demand for real money reserves (M / R) D includes all types of demand for money, namely: 1) transactional demand for money, which is the demand for money to buy goods and services (demand for money to make transactions, i.e. e. for transactions), arising from the function of money as a medium of circulation and their properties of absolute liquidity and positively dependent on the level of income (M / R) D T = (M / R) D (Y); 2) the demand for money from a precautionary motive, also positively dependent on the level of income; 3) speculative demand for money arising from the function of money as a stock of value, i.e. as a financial asset and negatively dependent on the interest rate, which in the Keynesian model represents the opportunity cost of keeping cash, showing a person's loss of income if he stores all his financial assets in the form of cash, refusing to buy profitable (interest-bearing) securities (bonds): (М / Р) DA = (М / Р) D (R). The higher the interest rate, the less money it is advisable to have it in cash. The lower the interest rate, the more attractive the liquidity property becomes, and people begin to sell bonds, increasing the amount of cash. (It is no coincidence that Keynes's theory of money is called the "liquidity preference theory"). Thus, a person prefers to have a so-called "portfolio" of funds, which includes both cash and securities. Portfolio structure, i.e. the ratio of monetary and non-monetary financial assets in it varies depending on the dynamics of the interest rate. It will be optimal if it gives the maximum income with the minimum risk.
As a result, if the money demand functions are linear, the total money demand can be written as a function:
(M / R) D = (M / R) D T + (M / R) D A = kY - hR,
where (М / Р) D Т - real transactional demand for money, (М / Р) D A - real speculative demand for money, Y - real income, k - sensitivity of demand for money by income or liquidity ratio, i.e. a positive coefficient showing how the real demand for money changes when the level of income changes per unit; R is the interest rate, h is the sensitivity of the demand for money to the interest rate or a positive coefficient showing how the real demand for money will change when the interest rate changes by one percentage point; the minus sign in front of h means the inverse relationship (an increase in the interest rate reduces the demand for money and vice versa).
As a result, the total money demand curve has a negative slope due to its inverse relationship with the interest rate.
Since the money supply (M) is determined by the central bank, this value is exogenous and fixed and graphically represents a vertical curve.
Equilibrium in the money market is established at the intersection of the money demand curve with the money supply curve. Economic Mechanism the establishment of this equilibrium is also explained by the Keynesian theory of liquidity preference, which is based on the position of the negative relationship between the interest rate and the price of bonds. The movement of the interest rate towards equilibrium occurs because people begin to change the structure of their portfolio of assets. (At an equilibrium interest rate, the ratio of monetary to non-monetary assets in the portfolio is optimal). Both the change in the demand for money and the change in the supply of money lead to a change in the interest rate. If the demand for money increases and the supply remains unchanged, the interest rate rises as people will sell bonds. In the bond market, supply begins to exceed demand, and the price of bonds falls. And since the price of a bond is inversely related to the interest rate, the rate rises.
The interest rate also increases when the central bank reduces the money supply. The decrease in the money supply forces people to sell bonds, which will have an effect similar to the one presented above. And vice versa. If the demand for money decreases, or the Central Bank increases the supply of money, the interest rate falls.
However, not only the value of the interest rate R affects the amount of demand for real money reserves, affecting the equilibrium of the money market. Y's income level also affects the demand for money. When income is high, expenses are high, people enter into more transactions, buying more goods and services and increasing the transactional demand for money.
Using these dependencies, it is possible to construct an equilibrium curve of the money market - the LM curve, showing the relationship between the interest rate (R) and the level of income (Y).
Plotting the LM curve. The LM curve shows all combinations of the income level Y and the interest rate R, at which the money market is in equilibrium, i.e. at which the real demand for money is equal to the real supply of money: (M / P) D = (M / P) S. We construct the LM curve in two ways:
In fig. 3. (a) The LM curve is plotted on the basis of the money market equilibrium graph (derived from Keynesian liquidity preference theory). An increase in the level of income (from Y 1 to Y 2) increases the demand for money, shifting the M D curve to the right, which increases the interest rate from R 1 to R 2. This allows us to construct an LM curve showing that a higher rate of interest will correspond to a higher level of income to ensure equilibrium in the money market. Therefore, the slope of the LM curve is positive.
In Figure 14.3. (B) the LM curve (graph IV) is derived from the principle of equality of the total demand for money (including: 1) the transactional demand for money, depending on income and represented by the curve (M / P) DT in the II graph, and 2 ) speculative demand for money, depending on the interest rate and depicted by the curve (M / P) DA in the III graph) money supply (the curve (M / P) S, shown in the I graph in the III quadrant, which shows the budget constraint imposed by a fixed amount money in the economy). At the income level Y 1, the transaction demand for money is equal to [(M / P) D T] 1, then with the existing value of the money supply in the economy, the speculative demand for money will be [(M / P) D A] 1, which corresponds to the interest rate R 1. If the income level rises to Y 2, the transactional demand for money will be [(M / P) D T] 2, at which the speculative demand for money is [(M / P) D A] 2, which corresponds to the interest rate R 2. Thus, a higher level of income corresponds to a higher rate of interest.
Points outside the LM curve. All points outside the LM curve correspond to money market imbalance. Consider point A (Fig. 3. (b)), which is above the curve LM. At this point, the income level is Y1, which corresponds to the transaction demand for money [(M / P) D T] 1, and the interest rate is R2, which corresponds to the amount of speculative demand for money (M D A) 2. The sum of these values of demand for money corresponds to the value of money supply, characterized by point A 'lying on the curve, where the money supply is less than that available in the economy (curve (M / P) sup> S). Thus, at all points above the LM curve, the supply of money exceeds the total demand for money, which means an excess supply of money (ESM). At point B, which is below the LM curve, the transaction demand for money will be [(M / P) DT] 2, since the income level is Y 2, and the speculative demand for money is [(M / P) DA] 1, since the rate percent is equal to R 1. The sum of the demand for money corresponds to the value of the money supply at point B ', where it is less than that in the economy. Thus, in this case, the demand for money is higher than the supply of money. Consequently, at all points below the LM curve, there is excess demand for money (ESM). In order for equilibrium to be established at these points, it is necessary that either the level of income change, or the value of the interest rate, or both. If the interest rate falls, then the demand for money increases; if income falls, the demand for money falls.
Algebraic analysis of the LM curve. Assuming that the money demand function is linear, an algebraic expression for the LM curve can be obtained:
(М / Р) S = kY - hR,
where (М / Р) S - money supply, kY - transactional demand for money, (- hR) - speculative demand for money. From this equation we obtain the value of the equilibrium income level:
Y = (1 / k) (M / P) S + (h / k) R (1)
and the value of the equilibrium interest rate:
R = (k / h) Y - (1 / h) (M / P) S (2)
The equilibrium income equation gives the amount of income that ensures the equilibrium of the money market at any value of the interest rate and the value of the real money supply. Similarly, the equation of the equilibrium interest rate shows the value of the rate that equilibrates in the money market for any value of income and value of the real money supply. The real money supply is fixed along the LM curve.
Since the coefficient at Y in equation (2) is positive (k / h> 0, since k> 0 and h> 0), the LM curve has a positive slope and reflects a direct relationship between the level of income and the interest rate. Higher income determines a higher demand for money, which leads to a higher rate of interest.
LM Curve Shifts. Shifts in the LM curve are due to changes in the nominal money supply (M S). Since the price level is fixed (P = const), a change by the central bank in the amount of money in circulation changes the real money supply (M / P) S. Since the coefficient at (M / P) S in equation (1) is positive, an increase in the money supply leads to a shift of the curve to the right by a distance ΔM (1 / k), while its contraction shifts the curve by the same distance to the left.
The slope of the LM curve.( h).
Decreasing h increases the slope of the LM curve (it becomes steeper) and at h = 0 the curve becomes vertical. With an increase in h, the LM curve becomes flatter. As k decreases, the LM curve will be flatter, and as k increases, it will be steeper.
Thus, the LM curve will be flatter if:
. the sensitivity of the demand for money to a change in the interest rate (h) is high (the demand for money is sensitive to a change in the interest rate). This means that even a small change in the interest rate leads to a significant change in the demand for money;
. the sensitivity of the demand for money to changes in income (k) is not high (the demand for money is insensitive to changes in income). A significant change in income causes a slight change in the demand for money.
Macroeconomics
The construction of the LM curve is based on the Keynesian theory of liquidity preference, which explains how the ratio of supply and demand of real stocks of cash determines the interest rate. Consider the construction of the LM curve based on a graphical analysis of the equilibrium of the money market. Plotting the LM Curve Method One In fig. The intersection of the demand curve with the money supply curve gives us the interest rate r1 which balances the money market for a given income level Y1.
67. Model LM
LM curve (“liquidity preference - money supply») Shows all possible ratios Y and r for which the demand for money is equal to the supply of money... The term LM reflects this equality: L (Liquidity Preference) denotes the preference for liquidity, the Keynesian term for the demand for money, and M (Money Supply) for the supply of money.
The LM curve is based on the Keynesian theory of liquidity preference, which explains how the ratio of supply and demand of real stocks of cash determines the interest rate. Real cash holdings are nominal stocks adjusted for price level changes and equal to M / R. According to the liquidity preference theory, the supply of real money is fixed and determined by the central bank. Consider the construction of the LM curve based on a graphical analysis of the equilibrium of the money market.
Rice. 6.5. Curve plotting LM (first way)
In Figure 6.5, the money supply curve is a vertical line that corresponds to a given real amount of money in the economy. The intersection of the demand curve with the money supply curve gives us the interest rate r1, which balances the money market for a given income level Y1. If income increases to Y2, then the money demand curve shifts to the right, and a higher level of income corresponds to a higher equilibrium interest rate r2. The collection of all pairs (Y, r) that balance the money market will give us the LM curve.
Just as the economy tends to the equilibrium points lying on the IS curve, it also tends to the equilibrium points determined by the LM curve (Figure 6.6).
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Viral hepatitis. Cholera. Poliomyelitis Section Viral hepatitis Viral hepatitis is a group of acute human infectious diseases that have clinically similar manifestations, are polyetiological, but differ in their epidemiological characteristics ... | |||
5551. | From Neoplatonism to Medieval Philosophy | 92.5 KB | |
From Neoplatonism to Medieval Philosophy Question 1 Neoplatonism and ancient science. Strive not only to be outside of sin, but to be God (Plotinus). Philosophers about Plotinus and his teacher. The last stage in the development of ancient philosophy is neoplatonism. Main... | |||
5552. | Characteristics of the stages of modeling Delivery and formalization of the problem | 122 KB | |
The meaning and content of the Problem Statement stage Problem statement is the first stage of modeling. The critical importance of this stage for the success of the study is noted in all works devoted to the methodology of modeling. Formulate the problem ... | |||
5553. | Guardianship and Guardianship in Civil Law | 150.5 KB | |
Introduction In any society there may be persons who have rights (legal capacity), but do not have a sufficient degree of understanding and maturity of will to independently manage their affairs (incapacitated). Such are - minors and without ... | |||