Lecture 8

Relationship between the Money and

Goods Markets
AD/AS
IS-LM Analysis
 Learning Outcome
• brings together the analysis of the goods and
money markets.
• to show how changes in the one market will
affect another and how an ‘equilibrium’ for the
economy can be formed.
• Analysis of monetary policy using MD/MS and
AD/AS
• analysis of fiscal and monetary policy using IS-
LM model
 Lecture 8
Relationship between the Money and
Goods Markets
MS/MD and AD/AS
 Money Demand, (L) and Money supply (M)
LM
Monetary transmission mechanisms
Interest rate transmission mechanism
GDP
Investment Aggregate (Y) 
Money Interest
 demand 
supply  rate  Prices
Saving 
(P) 

Money
supply  ……………………………….. vice versa
 Monetary Policy and Business Cycle
(from lecture 7)
• If the economy is in:
• Inflation gap – inflation is rising (& shortage of resources)
– central bank applies contractionary (tight) monetary
policy

• Recession gap - high unemployment – expansionary

(easy) monetary policy.

– Objective – to minimize the output gap and achieve low

inflation (and full employment)
Monetary PolicyCommercial
– effect bankson Money Market

Business Central Bank Monetary Banks’ Money Money Interest

Cycle Applies…. Policy Tool Reserves Supply Market Rates
Recession Expansionary OMO   MS > i
gap policy – central MD (+)
Easy or loose bank buys Surplus
securities of
money
Inflation Contractionary OMO   MS < i
gap policy – central MD (-)
Tight bank sells Shortage
securities of
money
Monetary Policy – Effect on Goods Market
Interest Aggregate Goods Price Real Economy
Rates Demand Market levels GDP

i C and I  AD > Prices Y

AS (-) 
Shortage Back to
of goods potential
& output / full
services employment

i C and I  AD < Prices Y

AS (+) 

Surplus
of
goods &
services
 The Central Bank Fights Recession:
Effects of Expansionary Monetary Policy
Central bank buys securities (bonds) in open market
operations (OMO) -  banks’ reserves - MS to MS1
Interest
MS0 MS1
rates % At r0 MS>MD (surplus)
r to r2
Opportunity
a Banks with excess reserves will
r0 cost of holding
money in bonds
falls as r falls
lend & buy bonds (& other assets)
r1 b Asset demand for money  -
MD0 bonds price 

Real money ($
billions) Surplus is resolved & money
market settles at new equilibrium
at lower interest rate r1
Targeted MS1 MS2 i%
interest
rate , r %
Other
r1 interest i1
rates fall
r2 i2
I
MD

Investment ($)
Price LRAS
Investment
increases
SRAS
P1 b
P0 a
Expansionary
Monetary Policy &
AD2 the Domestic
AD1
Y0 Y1 Y Economy
Goods & Services Market 9
 The Central Bank Fights Inflation :
Effects of Contractionary Monetary Policy
Central bank targets a higher interest rate at r1
To set at r1 Central Bank SELLS bonds in OMO
 banks’ reserves  & MS curve shifts left to MS1
Interest
rates %
Shortage of money MD < MD (-) at r0
MS1 MS0
 r:-
Opportunity
cost of holding
 Higher r force demand for bonds to fall
r1 - ●b money in & banks sells bonds to avoid losses
bonds rises as when bond prices fall
r rises
r0
Shortage is resolved at higher
interest rates as money market
MD0 clears at new equilibrium at pt b
Real money
10
balances
r, i% MS1 MS0 i%

Other
r2 b interest i2
rates rise
r1 i1

MD0 ID

Investment ($)
Price LRAS
level Investment
falls
SRAS0
P0
a
P1 b Tight Monetary Policy
• Central Bank announces
AD0 intention to interest rate
AD1 • Sells govt. securities
Y1 Y0
Real GDP
11
Goods & Services Market
 The Money Market:
Changes to Equilibrium
 in GDP / prices - Transaction demand for money
Interest MS
rates % At r0 MD > MS (shortage)
Opportunity
cost of holding  r to r2
b money in bonds
r1 rises as r  Bond prices  – demand for bonds  -
banks sells bonds to avoid losses
r0 a
Asset demand for money 
Shortage clears and money market
MD0 MD1 settles at new equilibrium at higher
interest rate r1
Real money ($
billions)
 Lecture 8
Relationship between the Money
and Goods Markets
IS/LM
 The goods market and the IS relation

AA Review
Review

• Equilibrium in the goods market:

AE = Y
Production = Y (also real GDP, also Income)
• AE = C + I + G + NX
C = a + b(Y – ty – T + TR)
• Equilibrium: Y = C + I + G + NX
• Changes in C, I, G & NX impact the equilibrium Y

Slide #14
The Investment Schedule, IS curve

Equilibrium:
AE = C + I + G + NX
Y = AE at equilibrium
Y = C + I + G + NX
Output (Supply) of Demand for
Goods Goods

Slide #15
 expenditure
Aggregate
b

AE2
The IS curve
AE1

a
Investment rises & At point a, AE > Y (-) Signal for firms to
the AE curve shifts
up to AE2 increase output

45o
Real GDP
Y1 Y2 $bn
Rate of interest

Results in a multiplier
effect when ∆Y > ∆I
a The IS curve
i1
represents points of
Assume a fall
equilibrium in the
b goods & services
in the interest i2
rate to i2 market where AE = Y
Y increases from Y1 to Y2
at equilibrium point b IS
Real GDP
Y1 Y2 $bn
Shifts in the IS Curve
An increase in taxes or decrease in G, fall in TR will shift the
IS curve to the left
Interest Rate, i

IS IS”

IS´

Y´ Y Output, Y

Slide #17
Financial Markets and the LM Curve

Money
Money market
market equilibrium
equilibrium revisited
revisited

M = money supply (controlled by

the Central Bank)
L = Money demand

Equilibrium
EquilibriumInterest
Interest Rate:
Rate:
MD
MD==MSMS
LL == M
M

Slide #18
Financial Markets and the LM Relation

Remember from last lecture, money demand is

affected by:
• Real GDP (Income)
• Prices
• Interest rates

Slide #19
 Money market equilibrium: deriving the LM curve
Assume a rise in real GDP to Y2
Money market arrives at
Raises the demand for money to MD" new equilibrium, b
And the interest rate rise to r2
MS LM

This gives point b

Rate of interest

Rate of interest
on the LM curve.
OC of holding
bonds↑, Dd for b
r2 b bonds↓, Qty of Md↓ r2
r1 a Md > Ms (-)
r1
a
MD "
MD '

O O Y1 Y2 Output
Money

The LM curve represents points of equilibrium in the money

market where L = M (Ms = Md)
 Equilibrium: The IS-LM Model

IS: Y = C + I + G + NX
The IS curve represents points of equilibrium in
the goods & services market where AE = Y

The LM curve represents points of equilibrium in

the money market where L = M (Ms = Md)
LM: MS = MD

Slide #21
 Equilibrium: The IS-LM Model

IS = LM
Equilibrium where IS = LM is the point where a
both the goods and the money markets are at
simultaneous equilibrium

Slide #22
Equilibrium in both the goods and money markets
LM
Rate of interest

i & Y is the only interest rate,

output combination that yields
a simultaneous equilibrium in
e the goods and financial
●
ie markets

IS

O Ye
National income
 Equilibrium in both the goods and money markets
LM
Rate of interest

The interest rate

e rise will reduce
● Investment and real GDP
a b below Y2.
r1
With income rising (Y2>Y1),
interest rates rise & there will be a IS
movement up the LM curve.

O Y1 Y2
National income
Shifts in the LM Curve: Showing changes in Ms
Loose Monetary Policy

Interest MS1 MS2 Interest

rates rates LM
LM2

a a
i1 MS > MD (+) i1

i2 b b
i2
Md IS

Money Y1 Y2 Output
 Shifts in the IS Curve:

expenditure
AE=Y

Aggregate
b AE2 Showing changes in Fiscal
 AE3
Policy
c AE1

Suppose government
a
 increase G

Y =  x G
45
o

Y1 Y3 Y2 Output
Interest

Intertemporal substitution
rates

effects – as i↑, C or I↓
LM
i2 c Intertemporal substitution
 effects – as i↑, C or I↓
i1  b
a IS2

IS1 Money market

finds new
equilibrium
26
Y1 Y3 Y2 Output
 NEXT WEEK
The International Business
Environment: Exchange Rates and
Balance of Payments