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Fundamental inflexibility assumptions: W -- inflexible P -- inflexible i -- flexible Overriding theme -- The interest rate changes as a result of monetary policy (money supply) as well as other factors.
The IS Curve
Re-translation of Simple Keynesian model at equilibrium (Investment = Saving). A plot of equilibrium output for various interest rates within the market for goods and services.
Decreases in autonomous expenditure which shift the EP curve downward, simultaneously shift the IS curve leftward. The steepness or flatness of the IS curve describes the elasticity or responsiveness of C and I to the nominal interest rate. -- Steep IS curve: inelastic. -- Flat IS curve: elastic.
Major advantage of holding money implies that we demand money in real units. The Demand for Money (L) -liquidity preference. For a given level of real wealth, the demand for money covers the entire financial asset holding decision (Walras Law).
The LM Curve
Depicts equilibrium in the money market (L = M), as well as the Bond Market (by Walras Law). A plot of the equilibrium interest rate for various levels of output or income, within the money market for a given level of the nominal money supply.
Decreases in the real money supply (MS or P) shift the LM curve leftward. The steepness or flatness of the LM curve describes the elasticity or responsiveness of money demand (L) to the nominal interest rate. -- Steep LM curve: inelastic. -- Flat LM curve: elastic.
Policy Effectiveness
An effective policy is one that obtains a large output response for a given change - Policy effectiveness depends upon the steepness or flatness of the IS and LM curves.
Decomposition of Policy
Fiscal and monetary policies change interest rates as well as output. This property implies that, for a given policy, Total Effect = Primary Effect + Secondary Effect.
Primary Effect -- Effect of a policy due to factors other than how it changes i*. Secondary Effect -- Effect of a policy due to how it changes i*. Policy Effectiveness -- based upon size of the secondary effect.