Lecture outline The IS curve Chapter The Demand for

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					                                                                                                                      Lecture outline
                                                                                                                       •   The IS curve (Chapter 10)
     Econ 202 Economic Theory II                                                                                       •   The Demand for money (Chapter 15)
                         March 20th, 2007                                                                              •   The LM curve (Chapter 10)
                                  ´
                                 Sebastien Blais
                           sblais@sebastienblais.com
                               blais@bilkent.edu.tr
                 www.sebastienblais.com/teaching/econ202.html
                                  Office: A212
Office Hours : Wednesday 10.40 - 11.40, Thursday 10.40 - 11.40, or by appointment.


                            Department of Economics
                                Bilkent University

                                                           Econ 202 Economic Theory II - March 20th, 2007 – p. 1/21                                        Econ 202 Economic Theory II - March 20th, 2007 – p. 2/21




The IS curve                                                                                                          The IS curve

In the income-spending model, we now make                                                                             A linear function is a good first-order
investment depend on interest rates                                                                                   approximation
         AD(Y, i) = C(Y ) + G + I(i) + N X                                                                                                       ¯
                                                                                                                                          I(i) = I − bi

We will want to consider the set of (Y, i) such that                                                                  What is the sign of b?
AD(Y ∗ , i) = Y ∗
                                                                                                                       •   more investment projects are profitable when
                                                                                                                           interest rates are lower

                                                                                                                      What about the magnitude of b?


                                                           Econ 202 Economic Theory II - March 20th, 2007 – p. 3/21                                        Econ 202 Economic Theory II - March 20th, 2007 – p. 4/21
The IS curve                                                                                    The IS curve
                                                                                                                                    ¯
                                                                                                What affects autonomous investment, I?
                                                                                                 •   expectations
                                                                                                 •   changes in the marginal product of capital




                                     Econ 202 Economic Theory II - March 20th, 2007 – p. 5/21                                        Econ 202 Economic Theory II - March 20th, 2007 – p. 6/21




The IS curve                                                                                    The IS curve: decreasing i
                         ¯
              AD(Y, i) = A + δY − bi
¯
A is now autonomous with respect to both i and
Y.
In the Y − AD space
 •   a change in i shifts the AD curve.
 •   a change in b shifts the AD curve.
 •               ¯
     a change in I shifts the AD curve.


                                     Econ 202 Economic Theory II - March 20th, 2007 – p. 7/21                                        Econ 202 Economic Theory II - March 20th, 2007 – p. 8/21
The IS curve                                                                                      The demand for money

How do the parameters affect the IS curve?                                                        Definitions of money, the issue being how quickly
 •   a change in i is a change along the IS curve.                                                can money be turned into consumption:
 •   a change in b shifts the IS curve.
                                                                                                   •   currency
 •                ¯
     a change in A the IS curve.
                                                                                                   •   currency + demand deposits (M1)
 •   a change in the multiplier changes the slope
                                                                                                   •   M1 + small time deposits (M2)
     the IS curve.                                                                                 •   M2 + large time deposits (M3)
                                                                                                   •   M3 + liquid money market assets (L)

                                                                                                       real money = nominal money / price level

                                       Econ 202 Economic Theory II - March 20th, 2007 – p. 9/21                                         Econ 202 Economic Theory II - March 20th, 2007 – p. 10/21




The demand for money                                                                              The demand for money

Think of households investing their wealth in two                                                 Consumers demand real money (rather than
kinds of assets                                                                                   another asset) because it is useful as a
 •   money, not paying any interest                                                                •   medium of exchange (transaction and
 •   financial assets, paying interest or increasing                                                    precautionary motives)
     in value (opportunity cost, i)                                                                •   store of value (speculative motive)
                                                                                                   •   unit of account
The basic issue is:
                                                                                                   •   standard of deferred payment
Why would consumers hold important quantities
     of money if it doesn’t pay any interest?


                                      Econ 202 Economic Theory II - March 20th, 2007 – p. 11/21                                         Econ 202 Economic Theory II - March 20th, 2007 – p. 12/21
The demand for money

Transaction demand                                                                               Speculative demand
 •   increases with income (Y )                                                                   •   decreases with anticipated returns on other
 •   decreases with financial innovation                                                               assets
                                                                                                  •   increases with uncertainty with respect to
Precautionary demand                                                                                  returns on other assets
 •   increases with uncertainty with respect
     transactions                                                                                These considerations lead us to model real
                                                                                                 money demand as
                                                                                                                   L(Y,i)=kY-hi


                                     Econ 202 Economic Theory II - March 20th, 2007 – p. 13/21                                        Econ 202 Economic Theory II - March 20th, 2007 – p. 14/21




The demand for money                                                                             The supply of money
                                                                                                                           ¯
                                                                                                 The nominal money supply, M , is "fixed" by the
                                                                                                 Central Bank.

                                                                                                  •   more about how this in done in Chapter 16




                                     Econ 202 Economic Theory II - March 20th, 2007 – p. 15/21                                        Econ 202 Economic Theory II - March 20th, 2007 – p. 16/21
The LM curve                                                                                       The LM curve

Equilibrium in the money market is characterized
as
             M¯
              P = L(Y, i ) = kY − hi
                        ∗           ∗


It fixes the interest rate for a given level of
income, Y .
                                 ¯
                   i = h (kY − M )
                        1
                                 P

This is the LM curve.



                                       Econ 202 Economic Theory II - March 20th, 2007 – p. 17/21                                        Econ 202 Economic Theory II - March 20th, 2007 – p. 18/21




The LM curve                                                                                       The IS-LM model

How do changes in the parameters affect the LM                                                      •   the IS curve represents equilibrium in the
curve?                                                                                                  goods market in terms of Y and i
 •   a change in k changes its slope                                                                •   the LM curve represents equilibrium in the
 •               ¯
     changes in M change its position                                                                   money market in terms of Y and i
 •   changes in P change its position
                                                                                                   We now look at both simultaneously.




                                       Econ 202 Economic Theory II - March 20th, 2007 – p. 19/21                                        Econ 202 Economic Theory II - March 20th, 2007 – p. 20/21
The IS-LM model




                  Econ 202 Economic Theory II - March 20th, 2007 – p. 21/21