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Chapter 2: IS-LM model equations

1) Consumption, (C )
The value of goods and services purchased by households. Depends positively on
income, Y, and negatively on Taxes, T;

C = c0 + c1(Y−T) c0 ≥ 0, and 0 < c1 < 1


(+ -)

Y-T: disposable income


C0: autonomous spending, factors other than disposable income
C1: MPC, the increase in C resulting from a one unit increase in disposable
income.

2) Investment, (I)
Three broad categories; fixed business investment, residential investment, and
inventory investment. Demand for I depend positively on income, Y, and
negatively on the real interest rate, r;

I = I0 + b1Y − b2r, b1≥0, and b2≥0


(+ -)

I0: autonomous investment, effect on I of any variable other than Y and r.


b1Y: sensitivity of I to income, Y
b2r: sensitivity of I to the real interest rate.

3) Tax Revenue (T)


Depends on the structure of the tax system, taxes can be levied at a fixed amount
lump sum or, a specific rate on income and consumption.

T = T0 + τ1Y + τ2C, τ1 ≥ 0, and τ2≥0

T0: tax revenue raised through lump sum taxes


τ1Y: average tax rate on income
τ2C: average tax rate on consumption

4) Government spending, (G)


The demand for goods and services of the public sector.

G = G0 + g1Y + g2C

G0: fixed component of government spending


g1Y: change in public spending proportional to variations in income
g2C: change in public spending proportional to variations in consumption
5) The Demand for Money, (Md)
Is positively related to income and negatively related to the nominal interest rate.
The higher the level of transactions, the more money is demanded for C and I by
individuals, firms and government. The higher the interest rate, the higher is the
cost of holding money rather than bonds, and thus the lower is the demand for
money, the real demand for money is;

d
M
= h0 + h1Y − h2i, h1≥0,h2≥0
P
(+ -)

P: indicates the price level, constant (fixed in IS-LM model)


h0: the level of demand for money independent of income and the interest rate
h1Y: sensitivity of money demand to income
h2i: sensitivity of money demand to the nominal interest rate.

6) The Supply of Money, (Ms)


Is assumed to be independent of the interest rate and directly controlled by the
central bank, which makes changes through open market operations, real money
supply is;

s
M M
=
P P

M: is the level of nominal money supply chosen by the central bank.


P: fixed price level.

7) Aggregate Demand, (Z)


Is equal to the sum of C, I, and G:

Z =C+ I +G

Since aggregate income must always equal aggregate expenditure in a closed


economy, we have

Y=Z

The combination of the above give the fundamental income identity for a closed
economy;

Y=C+I+G

Which states that in equilibrium aggregate income must be equal to the sum of
the components of aggregate demand.
8) Equilibrium output in the goods market can be alternatively retrieved from the
equality between saving and investment in the loanable funds market.

Y=C+IG
(Y – T – C) + (T – G) = I

Term on the left is total saving of the economy.


(Y – T – C): private saving, S
(T – G): public saving

Therefore, the equilibrium output in the goods market can be alternatively


determined by saving equals investment.

S+T–G=I

In a closed economy, investment can be financed through a combination of


private and public saving.

9) The IS curve,  affected by fiscal policy (G, T)


Represents the combinations of income and the interest rate, such that the goods
market is in equilibrium. (Assuming government spending is exogenous g1 = g2 =
0, and taxes do not depend on C, t2 = 0)

1 1−c1 ( 1−τ 1 ) −b1 ¿


i ¿= ( c 0−c 1 T 0 + I 0 +G0 )− Y
b2 b2

i*: equilibrium nominal interest rate.


Y*: equilibrium GDP/income
IS curve is negatively related c1, MPC, the responsiveness of investment to
output, b, and the interest rate, b2.
It is positively related to the tax rate t1.

The intercept depends on autonomous spending. An increase (reduction) of


autonomous spending shifts the IS curve upward (downward). The position is also
affected by the responsiveness of investment to the interest rate, the larger b2
the smaller the intercept.

10) The LM curve,  affected by monetary policy (Ms, P)


Comprises combinations of the interest rate and income, for which the money
market is equilibrium. Computed combining equations for money supply and
demand, solving for the interest rate.

1 M h1 ¿
i ¿= (
h2
h0 − )+ Y
P h2

h1
: the slope of the LM depends on the sensitivity of money demand to
h2
income and the interest rate. The more money demand is sensitive to income,
relative to the interest rate, the steeper the LM curve.

If money demand does not respond to the interest rate, h2 = 0, LM curve is


vertical, the classical case. If money demand is very sensitive to the interest rate,
h2 = 00 (infinite), and the LM curve is horizontal.

Chapter 3: AD-AS model