Download IS LM - Banking - Lecture Slides and more Slides Banking and Finance in PDF only on Docsity! 1 BS2551 Money Banking and Finance The IS –LM Output and the interest rate are determined simultaneously in the goods and money markets. The output is determined by the goods market and national income, (the IS Curve). The interest rate is determined by the money market (the LM Curve). The determination of output at the aggregate level is the fundamental issue in macroeconomics. The interest rate effects output (through investment) and output effects the interest rate (through money demand), so its necessary to consider the simultaneous determination of output and the interest rate. This is done by solving the IS and LM curves simultaneously to determine the output and the interest rate. Docsity.com 2 The IS Curve The goods market and output is determined by the IS schedule which is defined as the following (assuming a closed economy), Y C I G= + + Investment is determined by two factors, sales and the interest rate. A firm facing an increase in sales will require greater investment in plants, machinery and new products to finance the sales. Thus, investment increases when sales increase. (This may not be the case for internet firms, but generally holds for ‘blue chip’ companies.) An increase in the interest rate will increase the cost of borrowing which will in turn decrease investment. Example, individuals borrow smaller sums then companies because of the higher cost of borrowing. Docsity.com 5 Md Ms= The central bank controls the money supply. The central bank increases money supply by simply printing more money. To reduce money supply they issue more bonds and once they are purchased there is less money in the economy. The central bank controls money supply for monetary policy. If money supply is controlled they control the interest rate. Increasing the Money supply reduces interest rates and vice versa. The money supply is the governments measure of controlling monetary policy, and government expenditure is the way they control fiscal policy in the economy. Both G and Ms are exogenous because both tools are used by the government to correct the free market if and when they choose to do so. Docsity.com 6 Empirical Example Y=C+I+G, C=Y-T, which is equal to disposable income. If C=200+0.25(Y-T) T=200, I=150+0.25Y-1000i. G=250, Is Curve (Y=C+I+G) ⇒Y=1100-2000i Money Demand = 2Y-8000i Money Supply = 1600. LM Curve ⇒ i= Y/4000-1/5. Substituting i from the LM curve into the IS curve gives: Y=1000, i=1/20, or 5%. Docsity.com
