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Numerical For Is LM

The document summarizes the Keynesian model of income determination. It presents the consumption function, investment function, and equilibrium condition. It shows how autonomous consumption, taxes, investment, and government spending determine aggregate planned expenditures and equilibrium income. It then introduces the IS-LM model to analyze monetary and fiscal policy. The IS curve shows real output and interest rate equilibrium, while the LM curve shows money market equilibrium. The model is used to analyze how changes in monetary and fiscal policy shift the curves and impact output and interest rates.

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Anish Bhusal
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382 views9 pages

Numerical For Is LM

The document summarizes the Keynesian model of income determination. It presents the consumption function, investment function, and equilibrium condition. It shows how autonomous consumption, taxes, investment, and government spending determine aggregate planned expenditures and equilibrium income. It then introduces the IS-LM model to analyze monetary and fiscal policy. The IS curve shows real output and interest rate equilibrium, while the LM curve shows money market equilibrium. The model is used to analyze how changes in monetary and fiscal policy shift the curves and impact output and interest rates.

Uploaded by

Anish Bhusal
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOC, PDF, TXT or read online on Scribd
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1

Keynesian Model of Income Determination


E = C + I + G + NX
C = Ca + c(YT)

By Definition
Consumption Function

Note:
Ca = Autonomous Consumption (500)
c = Marginal propensity to consume (0.75)
c(YT) = Induced Consumption.
P = fixed, r = Fixed, T = Personal taxes (Fixed) &
(YT) = Personal disposable income.

45

)C = (Y-T

So, C = 500 + 0.75(YT)

At: (YT) = 8000 C = 6,500


S = (YT) C = Ca + (1-c)(YT)
Where: (1 c) (YT)

Ca

(Y-T)

is "Induced Saving"

So, S = 500 + 0.25(YT)


At: (YT) = 8000 S = 1,500

To Establish Equilibrium:

E Ep = 0
Since:

Y=E

Then:

Y Ep = 0 Y = Ep

Ca

(Y-T)

But: Ep = C + Ip + G + NX
Ep = Ca + c(YT) + Ip + G + NX
Ep = Ca cT + Ip + G + NX + cY
Rewrite as:
Where:

Ep = Ap + cY

Ap = Ca cT + Ip + G + NX

Autonomous Planned Spending


Note:

Ep
Y
Ap

45

Y = Ep

Ep
1

T = Ta

Let: Ca = 500, c = 0.75, Ip = 1200, NX = 200, G & T = 0


1

So, Ap = 500 0.75(0) + 1200 + 0 200 = 1,500


Ep = 1500 + 0.75Y
At Equilibrium:

Y = Ep

Or:

Y = Ap + cY

Income Produced must equal planned expenditures by sectors.


If:

Y > Ep

Then:

Iu > 0

There is: Unintended Inventory Accumulation


If:

Y < Ep

Then:

Iu < 0

At: Y = 6000 Ep = 1500 + 0.75(6000) = 6000


So, Y* = 6000 & Iu = 0
If:

Y = 8000 Ep = 1500 + 0.75(8000) = 7500

Then:

Iu = + 500

"Not at equilibrium"

Rewrite the Equilibrium Condition:


Y = Ap + cY

Or:

Y cY = Ap

(1 c)Y = Ap

Or:

s Y = Ap

Note:

Induced Saving = Autonomous Planned Spending

Induced Leakages = Injections


Since: Ap = 1500, Then: 0.25Y = 1500 Y* = 6,000
Rewriting:

Y* = Ap / s = k Ap

Where:

k - the multiplier

sY

Ap & sY

Ap1 = 2000

Suppose: Ip = 1000 Ap1 = 2000


Then:

Y1 = 2000 / 0.25 = 8,000

Recall: Ip = 500 Ap0 = 1500


Note:

Ap2 = 1500

6000

8000

Then: Y0 = 1500 / 0.25 = 6,000

Multiplier ( k ) = Y / Ap = 2000 / 500 = 4

Recall:

Ap = Ca cTa + Ip + G + NX

So:

Ap = Ca cTa + Ip + G + NX
2

Hence:

Multiplier for Ca , Ip , G & NX is: k = 1 / s = + 4


Multiplier for Ta is = c / s = 0.75 / 0.25 = 3

Government Surplus: T G = I + NX S
Alternatively: S +T = I + G + NX

Leakages = Injections

The General Case:


Introduce: Income Taxes & Endogenous NX
T = Ta + tY
Recall:

&

NX = NXa nxY

Ep = C + Ip + G + NX
Ep = Ca + c(Y Ta tY) + Ip + G + NXa nxY
Ep = Ca cTa + Ip + G + NXa + cY ctY nxY
Ep = Ap + c(1 t)Y nxY

At equilibrium:

Y = Ep

Y c(1 t)Y + nxY = Ap


[1 c(1 t)]Y + nxY = Ap
[s(1 t) + t + nx]Y = Ap

(Shift induced parts to left)


1 c(1 t) = (1 c) + ct
= s + (1 s)t
= s + t st
= s(1 t) + t

[MLR]Y = Ap
Ca cTa + Ip + G + NXa
Y* = Ap / MLR = --------------------------------s(1 t) + t + nx

Another proof for: [1 c(1 t)]Y = [s(1 t) + t]Y


Y = C + S + T Y = C + S + T
Y = c(1 t) Y + s(1 t) Y + t Y
1 = c(1 t) + s(1 t) + t

1 c(1 t) = s(1 t) + t

The IS - LM Model
(1) The IS Curve: Shows equilibrium in the real sector
3

Based on Rate-of-return analysis, we can show that:


Ip + Ca 1/r Ip + Ca = 2500 100 r

RoR & r
Int. Rate

10

(Higher r reduces both)

If r = 0 & r = 10

(Ip + Cp)

Then: Ip + Ca = 2500 & 1500

1500

2000

2500

Note: Optimism & Confidence shifts (Ip + Cp) Right.


r

The Ap Demand Schedule:

15

Since: Ap = (G cTa + NXa ) + (Ca+ Ip)

Ap Demand
Schedule

10

(G cTa + NXa ) is given &

A'p0

(Ca+ Ip) is related to r

1000 1500

2000

Ap

2500

If: G = Ta = NXa = 0
Then: Ap = 2500 100r
Ap = A'p0 br
At Equilibrium:

(A'p0 is Ap @ r = 0)

(MLR) Y

Ap

Y = k Ap

2000

The IS Curve

Y = k [A'p0 b r ]

Equation:

Y = 4 [2500 100 r]

1500

6000

Ap (r = 10)
8000

Y = 10,000 400 r
r

- What shifts the IS curve?


- What are the channels through

15

which interest rate influence

10

components of Ap?

IS(A'p0 = 2500, k = 4)
B
C

kA'p0

4,000

Ap (r = 5)

6,000

8,000

10,000

(2) The LM Curve: Shows equilibrium in the financial sector

(M/P)d = f(Y, r)

Or: (M/P)d = h Y f r

(M/P)d = 0.5Y 200r


Note: for every level of Y there is

(Ms/P) = 2000

a new money demand curve.


Example: For: Y = 8000

LM0 (Y=8000)

10

Then: (M/P)d = 4000 200r

L1 (Y=6000)

For: Y = 6000

2000 3000 4000

Then: (M/P)d = 3000 200r

M/P

For Equilibrium in Money Market (LM Curve):


Ms /P = (M/P)d

Ms /P = h Y f r

LM Curve

- For a given Ms /P, Y & r positively related.


Ms /P = 0.5 Y 200 r

LM0 (Ms/P=2000)
LM1 (Ms/P=3000)

- If: Ms /P = 2000, then:


LM: 2000 = 0.5Y 200 r

15

At: Y = 8000, r = 10 point F

10

At: Y = 6000, r = 5

point G

F
G

- If Ms /P = 3000, then:

4,000 6,000 8,000

New LM: 3000 = 0.5Y 200 r


At: Y = 8000, r = 5

& At: Y = 6000, r = 0

Ms/P

LM
Points of LM

Falling Y shifts money demand left.

Changing r moves on money demand.


5

The IS Meets The LM


IS0 (A'p0 = 2500, k = 4):

Y = k(A'p0 br)

LM0 (Ms /P = 2000):

Ms /P = hY fr
E0

(IS0)
4000 7000 10000 Y

2000 = 0.5Y 200r


Y = 4000 + 400 r

LM0

IS0

7.5

Y = 4(2500 100r)
Y = 10,000 400 r

(LMo)

Solving the two equations:

Both markets are


at equilibrium at
E0

4000 + 400 r = 10,000 400 r


800 r = 6000
Equilibrium r = 6000 / 800 = 7.5

LM0 LM
1

IS0

Equilibrium Y = 4000 + 400 (7.5) = 7,000

If: Ms /P = 3000, then


3000 = 0.5Y 200r

E0

7.5

Monetary Policy:

E1

LM curve
shifts right

4000

6000

7000

Y = 6000 + 400 r
Solve for Equilibrium again (E1)
6000 + 400 r = 10,000 400 r
800 r = 4000
New r = 4000 / 800 = 5
New Y = 6000 + 400(5) = 8000
Transmission Mechanism for Monetary Policy:
Ms/P Saving & Bonds r Ap Y*

10000
8000

Fiscal Policy:

Start with Original IS0 & LM0


IS0: Y = 4[2500 100 r] = 10000 400 r

10

LM0: 2000 = 0.5Y 200r

7.5

Or:

E0

E2

Y = 4000 + 400r

If: G = 500, then Ap = 500


IS1:

E3

4000 7000 8000 9000 10000 12000

Y = 4[3000 100 r]
Y = 12000 400 r

New equilibrium:

IS1 & LM0 at E3

12000 400 r = 4000 + 400 r 800 r = 8000 r* = 10


Y* = 12000 400 (10) = 8000
Note: With simple multiplier income should rise by 2000 (at E2).
But: At E2 money market not in equilibrium (r must increase).
So:

Rise in r cuts the multiplier to 2 instead of 4.

Important: Even though income has increased, the composition


of spending is different at E3 compare to E2.
Recall: Y = Ap + c Y

& Ap = Ca + Ip + G + NX cTa

At E0 (r = 7.5): Ip + Ca = 2500 100 r = 1750

& G=0

etc.

Ap (at r = 7.5) = 1750 Y = 4 (1750) = 7000


Induced consumption = c Y = 5250 Y = 1750 + 5250 = 7000
At E3 (r = 10): Ip + Ca = 2500 100 r = 1500
Ap (at r = 10) = 2000

& G = 500

Y = 4(2000) = 8000

Induced consumption = c Y = 6000 Y = 2000 + 6000 = 8000


Hence: Autonomous private spending decreases from 1,750 to 1,500.
7

Induced consumption spending increases from 5,250 to 6,000.

Can the crowding out be eliminated to get maximum


increase in Y?
Yes: Keep r fixed by shifting the LM to right.

Elementary Algebra of the IS-LM Model


Recall: Y = k Ap = k (A'p b r)

IS-Curve equation

And: Ms / P = (M / P)d = h Y f r
Y = 1/h (Ms / P) = (f / h) r

LM-Curve equation

To find the equilibrium:


Rewrite the LM equation as: r = (h/f)Y (1/f)(Ms /P)
Substitute in IS equation:
Y = k [A'p (b h / f)Y + b / f (Ms /P)]
Y + (k b h / f)Y = k A'p + k b / f (Ms /P)
[1 + k b h / f ]Y = k A'p + k b / f (Ms /P)
[1/k + b h / f ] Y = A'p + b / f (Ms /P)
Y = k1 A'p + k2 (Ms / P)
Where:

k1 = [1/k + b h / f ]-1
k2 = (b / f) [1/k + b h / f ]-1 = (b / f) k1

Given: k = 4, b = 100, h = 0.5, f = 200


k1 = 2.0 & k2 = 1.0
So:
At:

Y = 2 A'p + 1.0 (Ms /P)


A'p = 2500 & Ms /P = 2000 Y = 7,000

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