Advanced Macro Economics 3rd Day Lecture

Advanced Macro Economics 3rd day Lecture- Atty. Roentgen Jude Paolo L.
Ignacio
Continuation on the Lecture on the Financial Market
Two Alternative ways of looking at the Equilibrium
1. The Federal Funds Market and the Federal Funds Rate (In the Philippines this is called the
Interbank Call Loans)
In this way of looking at equilibrium, we look at the supply and demand for bank Reserves. The
supply for bank reserces is equal to the supply of central bank money H minus the demand for
currency by the public CUd. The demand for reserves by banks is Rd. So the equilibrium
condition that the supply and demand for bank reserves be equal is given by:
H- CUd = Rd
This equation is derived from the original equation for the demand for central bank money that
is Hd = CUd + Rd. Here H = Hd. To put it in words, looking at equilibrium in terms of the supply
and demand for reserves is equivalent to looking at the equilibrium in terms of the supply and
demand for money.
In the Philippines we have a market for bank reserves where the interest rate moves up and
down to balance the supply and demand for reserves. Banks that have excess reserves at the
end of the day lend them to banks that have insufficient reserves. We call this the interbank
call loans. In the United states this is the Federal Funds Rate.
2. The Supply of Money, the Demand for Money, and the Money Multiplier
_____1____H= $Y L(i)
[c + θ(1 - c)]
Supply of Money = Demand for money
The above equation is called the money multiplier. The right side is the overall demand
for money (currency plus checkable deposits). The left side is the ovreall supply of
money (currency plus checkable deposits). Basically the equation says that, in
equilibrium, the overall supply and the overall demand of money must be equal.
This equation basically tells us the overall effect of an increase in the supply of money
in the financial markets
Goods and Financial Markets: IS-LM Model
Previously in the Goods market we arrived in this equation:
Z = C(Y-T) + I + G
Demand Z is the sum of consumption, investment and government spending. We

assumed then that consumotion was a function of disposable income and took
investment spending, government spending and taxes as given.
Because of this the equilibrium condition is given by:
Y = C(Y-T) + I + G
Under this equilibrium condition, we then looked at the factors that moved equilibrium
output.
Investment, Sales and the Interest Rate:

Previously we looked at investment as constant. In reality however investment is far
from constant and primarily depends on 2 factors:
1. Level of sales- a firm that has an increase in sales will need to buy additional
machines or to build an additional plant to produce more of its goods and services. To
put it in business terms, it will need to invest. In contrast, a firm facing low sales will
have no such need and will spend little to nothing on investment.
2. Interest Rate- usually, a business buying machines and/or expaning its plants will
have to borrow money. The higher the interest rate, the less attractive it is to borrow
and buy new machines or expanding its plants.
The equation is then given as:
I = I(Y, i)
(+, -)
This equation states that Investment I, depends on production Y, and the interest rate I.
As a result, Y denotes sales and it also denotes production. The positive sign under Y
indeicates that an increase in production and sales leads to an increase in investment.
The negative sign under interest rate i, indicates that an increase in interest rate leads
to a decrease in investment.
Determining Output
Taking into account the new investment relation eqaution, the condition for equilibrium
in the goods market becomes:
Y = C(Y-T) + I(Y, i) + G
Production (on the leftside of the equation) must be equal to demand for goods (the
right side). This equation is called the expanded IS relation.
In this new equation, for a given value of interest rate i, demand is an increasing
function of output, because
 An increase in output leads to an increase in income and thus an increase in
disposable income. This incresae in disposabe income leads to an increase in
consumption.
 An increase in output also leads to an increase in investment.
This could be illustrated Graphically as:

If we compare this graph from our previous one, this is more flatter and instead of a
line, we have a curve. The reason is that first, in our previous lesson, investment was
treated as constant, hence the movement is more linear, in this case, investment now
responds to production and hence, when output increases , the sum of increase in
consumption and the increase in investment could exceed the initial increase in output.
Second is that, empirical evidence on this matter shows that the first reason is not
always the case in reality. This is specially true in developed economies.
Deriving the IS Curve
Explanation:
 The demand curve is given by ZZ, with the initial equilibrium point at point A
 Now there is an increase in interest rates from i to i’. This means that at any
level of output, the higher interest rate will give a lower level of investment and
lower demand
 The demand curve now shifts down from ZZ to ZZ’
 The ZZ curve is now plotted in the second graph with interest rates in the Y axis
and Output on the Horizontal axis.
 The downward sloping IS curve shows the inverse relationship between interest
rates and output
 IS means Investment-Savings
Shifts in the IS curve

 Taxes (T)- Increase in taxes will shift the IS curve to the left and a decrease in
taxes will shift the IS curve to the right
 Government Spending (G)- An increase in government spending will shift the
IS curve to the right and a decrease in government spending will shift it to the
left
 Consumer Confidence (C)- An increase in consumer confidence will shift the
IS curve to the right and a decrease in consumer confidence will shift the IS
curve to the left
Illustration of an increase in taxes
An increase in taxes will decrease output. Notice however that there is no change in
the interest rates
Financial Markets and the LM Relation
Previously the demand for money was given as M= $Y L(i)

This means that the demand for money is determined by the nominal income and the
interest rate.
Let us now re-write this equation in terms of of relation between money (that is money
in terms of goods), real income (income in terms of goods), and the interest rate
Remember that nominal income divided by the price level equals real income. The
equation is thus:
M = YL(i)
P
The new equilibrium condition is hence described as real money supply (which is the
money stock in terms of goods, here in designated as M/P) is equal to the demand, that
depends on real income Y, and the interest rate i.
Deriving The LM Curve
In this graph above there has been an increase in nominal income. This shifted the
demand for money upwards which also inreased the interest rate in our LM Curve (the
graph on the right).
Notice that the effect of an increase in nominal income on our LM curve is only a
movement along the curve. There is no shifting because only changes in the money
stock, designated as M/P in the graph above will only shift our LM curve
Let us illustrate for example an increase in the money supply from M to M’. As
illustrated below an increase in the money supply will shift the LM curve down, this
causes interest rates to move down from i to i’ while income remains the same
Notice that the LM Curve is upward sloping. This is because equilibrium in the
financial markets implies that, for a given real money supply, increase in the level of
income, which increases the demand for money, leading an increase in the interest
rate.
An increase in the money supply shifts the LM curve down; a decrease in the money
supply shifts the LM curve up
Putting the IS-LM model together
The IS relation follows from the condition that the supply of goods must be equal to the
demand for goods. It tells us how interest rate affects output.
The LM relation follows from the condition that the supply of money must be equal to
the demand for money. It tells us how output in turn affects the interest rate.
Putting it together, it shows that at any point in time, the supply of goods must be equal
to the demand for goods and the suppy of money must be equal to the demand of
money. Together they determine both output and the interest rate.
IS Relation: Y= C(Y-T) + I(Y,i) + G

LM Relation: M/P = YL(i)
Below the IS curve and the LM curve are plotted in one graph
At any point of the downward sloping IS curve corresponds to equilibrium in the goods
market. Any point on the upward sloping LM curve corresponds to equilibrium in
financial markets. At point A both equilibrium conditions are satisfied, that is, at this
point, with the associated level of output Y, and interest rate, i, is the overall equilibrium
which is the point at which there is equilibrium in both goods market and financial
markets.
The IS LM relations here in shown contains information about consumotion, investment,

money demand and equilibrium conditions. This holds alot of answers in macro
economics. It shows what happens to the output and interest rate when the central
bank decides to increase the money stock or when the government decides to increase
taxes, or when consumers become pessimistic and so on
Illustration 1: Increase in Taxes
Let’s have a scenario where the government decides to reduce the budget deficit and it
does so by increasing taxes while keeping government spending unchanged. We call
this type of fiscal policy as fiscal contraction/ fiscal consolidation (of course this includes
a scenario where the government decreases government spending). As a side note,
when the government does otherwise, i.e., it increases its deficit either through an
increase in government spending or a decreease in taxes, we call it a fiscal expansion.
The effect of a increase in tax rates is shown below

Note that the increase in taxes is denoted as T’ and the original taxes as T
Explanation:
 As established before, because of the multiplier effect, an increase in taxes
leads to a decrease in disposable income, this decreases consumption and
hence decreases output. This is due to the fact that in the short run demand
determines output
 By reason of taxes, our IS curve shifts to the left. Note that there is no effect in
our LM curve since there is no tax that is a variable in our LM equation. Taxes
only exist in our IS eqaution.
 Since there is no change in our LM curve our economy moves along in it.
 Because our IS curve shifted to the left by reason of taxes and there is no
change in our LM curve, our equilibrium point moved from A to A’. Note that at
this new equilibrium point, interest rates went down from i to i’ and output went
down from Y to Y’.
Effects of Increase in Taxation to the components of demand

The graphical illustration of what happens to the economy when the government
reduces the budget deficit through increase in taxation is above shown. What is the
explanation then on what happens with the components of demand(consumption,
government spending and investment)? Consumption goes down, since taxes goes up,
this means that disposable income decreases. What happens with investment is not
clear. A lower interest rate leads to higher investment but a lower consumption, means
lower output and hence lower sales. Since investment is determined both by sales and
interest rates, it cannot be clearly determined. This is true at least in our current short
run model
Illustration 2: Increase in Money Supply

An increase in money supply is called a monetary expansion while a decrease in
money supply is caled a monetary contraction or monetary tightening.
Let us illustrate a case of monetary expansion wherein the central bank decides to
increase money supply through open market operations. Let us denote the initial money
supply as M/P and the new money supply as M’/P
Explanation:
 Since the change in money supply here is on the LM equation, shifting will
occur on the LM curve. What occured here is an increase in money supply, this
will ineffect shift our LM Curve down from LM to LM’
 At this new equilibrium point, interest rate decreased from i to i’ but output
increased fromY to Y’
Effect of a monetary expansion to the components of demand

Note here that the effects of monetary expansion can be seen on the different
components of demand (consumption, government spending and investment). Since
income is higher and taxes are unchanged, disposable income goes up and so does
comsumption. This in effect means that sales are higher. Since sales are higher and
the interest rate is lower, investment goes up. So this means that a monetary expansion
is more investment friendly.

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Advanced Macro Economics 3rd day Lecture- Atty. Roentgen Jude Paolo L.

Continuation on the Lecture on the Financial Market

Two Alternative ways of looking at the Equilibrium

Previously in the Goods market we arrived in this equation:

Demand Z is the sum of consumption, investment and government spending. We

Because of this the equilibrium condition is given by:

Investment, Sales and the Interest Rate:

This could be illustrated Graphically as:

Deriving the IS Curve

Shifts in the IS curve

Financial Markets and the LM Relation

Previously the demand for money was given as M= $Y L(i)

Deriving The LM Curve

Putting the IS-LM model together

IS Relation: Y= C(Y-T) + I(Y,i) + G

The IS LM relations here in shown contains information about consumotion, investment,

The effect of a increase in tax rates is shown below

Effects of Increase in Taxation to the components of demand

Illustration 2: Increase in Money Supply

Effect of a monetary expansion to the components of demand

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