The Keynesian framework derives equilibrium conditions for the markets for goods, money, and labor, and synthesize them. The bond market equilibrium is guaranteed by Walras’ law. Walras’ law tells that the sum of excess demands across all the markets is equal to zero. In other words, in an economy with n markets, equilibrium in (n1) markets guarantees that the other market is already in equilibrium
Trang 2Outline (Based on B&J)
1 Markets in the Kyenesian world
The Goods Market and the /S Relation Financial Markets and the LM Relation Combining IS and LM Curves
Policy Simulations within the IS-LM Framework IS-LM and the Reality
Nn
Fe
Y
Trang 3Markets in the Keynesian World
O Today we will learn about the Keynesian Framework
(so called the IS-LM framework)
O Keynes considers that the following four types of markets in the economy constitutes the aggregate economy
A Goods Market (demand side)
A Money Market (demand side, financial market)
A Bond Market (demand side, financial market)
Trang 4Where Are We Headed for
O The Keynesian framework derives equilibrium conditions for
the markets for goods, money, and labor, and synthesize them
= The bond market equilibrium is guaranteed by Walras’
law
O Waltlras’ law tells that the sum of excess demands
across all the markets is equal to zero
O In other words, in an economy with n markets,
Trang 51 The Goods Market and the JS Relation
O Equilibrium in the goods market exists when production, Y, is equal to the demand for goods, Z This condition is called the /S relation
Y=Z
Z=C+1+G
Oln a simple model, the interest rate did not affect the
demand for goods The equilibrium condition was given by:
Trang 61 The Goods Market and the JS Relation
Investment, Sales, and the Interest Rate Investment depends primarily on two factors:
= The level of aggregate income, equivalent with that of sales, positively(+) related to investment
= The interest rate, an opportunity cost of investment, 1s
inversely(-) related to investment
I= I(Y,i)
Trang 71 The Goods Market and the JS Relation
Determining Output
“* Taking into account the investment relation, the equilibrium condition in the goods market becomes:
Y= C(Y-T)+1(Y,i)+G
“* For a given value of the interest rate i, aggregate demand iS an increasing function of output, for two reasons:
= An increase in output leads to an increase in income and also to an increase in disposable income
= An increase in output also leads to an increase in
Trang 81 The Goods Market and the JS Relation
Determining Output
Note two characteristics of the Aggregate Demand Z:
= So far it has been assumed that C and / are linear wrt Y
But in general Z is a curve rather than a line
= Z 1s drawn flatter than a 45-degree line because it’s assumed that an increase in output leads to a less than
one-for-one increase in demand (Remind the Paradox of
Trang 9
1 The Goods Market and the JS Relation
Equilibrium Demand
in the Goods Market 22
The demand for goods is an increasing function of output Equilibrium requires that the demand for goods be equal to
output
Demand,
Trang 10Deriving the /S Curve Demand, Z
(a) An increase in the interest “
rate decreases the demand for goods at any level of output, leading to a
decrease in the equilibrium ,
level of output Supa (b) Equilibrium in the goods
market implies that an
increase in the interest rate
Trang 11Shifts of the /S Curve
¢We have drawn the IS curve, taking as given the values of taxes, 7, and government spending, G Changes in either T or G will shift the ZS curve
-To summarize:
= Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output This relation is
represented by the downward-sloping /S curve
Trang 121 The Goods Market and the JS Relation
Trang 132 Financial Markets and the LM Relation
O The interest rate is determined by the equality of the supply of and the demand for money:
M = $YL(i)
M = nominal money stock $YL(i) = demand for money
$Y = nominal income
/= nominal interest rate
O The equation M = $YL(i) gives a relation between
Trang 142 Financial Markets and the LM Relation
O The interest rate is determined by the equality of the supply of and the demand for money:
M = $YL(i)
M = nominal money stock $YL(i) = demand for money
$Y = nominal income
/= nominal interest rate
O The equation M = $YL(i) gives a relation between
Trang 182 Financial Markets and the LM Relation
Deriving the LM Curve
s+ The plot 1n the right hand side of the previous slide
represents the equilibrium interest rate, 7, on the
vertical axis against income on the horizontal axis
Trang 202 Financial Markets and the LM Relation
Shifts of the LM Curve
WM Equilibrium in financial markets implies that, for a given real money supply, an increase in the level of
income, which increases the demand for money, leads to an increase in the interest rate This relation is
represented by the upward- sloping LM curve
Trang 213 Combining IS and LM Curves
Trang 224 Policy Simulations within the IS-LM Framework
Fiscal Policy, Activity, and the Interest Rate
OFiscal contraction, or fiscal consolidation, refers
to fiscal policy that reduces the budget deficit
OAn increase in the deficit is called a fiscal
expansion
Trang 23Fiscal Policy, Activity, and
the Interest Rate
Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output This is represented by the IS curve
Trang 24Monetary Policy, Activity, and the Interest Rate
O Monetary contraction, or monetary tightening, refers to a decrease in the money supply
O An increase in the money supply is called monetary expansion
Trang 264 Policy Simulations within the IS-LM Framework
The Effects of Fiscal and Monetary Policy
Movement Movement in
Shift of /S Shift of LM in Output Interest Rate
Trang 274 Policy Simulations within the IS-LM Framework
The combination of monetary and fiscal polices 1s known as the monetary-fiscal policy mix, or simply,
the policy mix
Sometimes, the right mix is to use fiscal and monetary policy in the same direction
Trang 285 IS-LM and the Reality
Introducing dynamics formally would be difficult, but we can
describe the basic mechanisms 1n words
= Consumers are likely to take some time to adjust their consumption following a change 1n disposable income = Firms are likely to take some time to adjust investment
spending following a change in their sales
= Firms are likely to take some time to adjust investment spending following a change in the interest rate
Trang 29Effect of 1% increase in federal funds rate on retail sales 5 IS-LM and the Reality 1.6 g 5 08 The Empirical Effects of s 04 an Increase in the 5 Federal Funds Rate 2 5
In the short run, an 3
Increase in the federal 16 rm
funds rate leads to a
decrease in output and
to an increase in
unemployment, but it has
little effect on the price level Percentage change in the unemployment rate (a) Time (quarters) 0.15 0.12 0.09 0.06 - 0.03 0.00 —0.03 ~0.06 r+r Percentage change in output Time (quarters) (d) Effect of 1% increase in federal funds rate on the unemployment rate Time (quarters) Effect of 1% increase in federal funds rate (b) (C) Effect of 1% increase in federal funds rate on output on employment 5Ö lồ Š t2 Š 8 08- 5 c 0.4 - ® a c a 5 ® a 8 Cc ® 2 & TT T TT TấT TT T —1.6 =+ TT T TT TấTT TT 4 8 4 8 Time (quarters) (e) Effect of 1% increase in federal funds rate on