ISLM Video Tutorial


Uploaded by micoschwartz on 17.11.2009

Transcript:
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ÿÿÿÿ ÿÿÿÿ ÿÿÿÿ ÿÿÿÿ ÿÿÿÿ " " " " " " " " " P } Í : " " " ~ This video
covers the finding simultaneous equilibrium in the goods market and the money market by
combining the IS and LM curves. This leads to a method for deriving the Aggregate Demand
curve. This model is also used to anticipate the economy's response to fiscal and monetary
policy. This slide displays the goods and services
market on the top right hand side. The money market is on the left.
First, in the goods market, the horizontal line is the equilibrium condition and the
aggregate demand equation extends upward. The equilibrium interest rate and level of
income are extended down to derive the IS curve. The higher interest rate results in
a higher equilibrium income. Connecting these points creates the IS Curve.
In the money market, on the left, the real money supply is the grey vertical line. When
the demand for money curve crosses it the equilibrium interest rate is found. For a
higher level of national income (Y2), the equilibrium interest rate is higher; these
points create the LM curve. The intersection of the IS and LM curves denotes
the equilibrium level of interest and income that will have both markets in simultaneous
equilibrium. From this information we can derive the aggregate
demand curve in the Price/Income graph on the top right. This is done by finding the
IS-LM equilibrium for different price levels. Price levels are in the real money supply
equation that is represented by the grey vertical bar. By drawing LM curves for different price
levels, we can produce enough points in the P/Y space to derive the aggregate demand curve.
The LM curve is drawn for the first price level, producing the first point at the intersection
of P1 and the resulting equilibrium level of national income.
A reduction the price level increases the real money supply because people can buy more
with the money they have. The lower price level shifts the money supply line outward.
This causes the LM curve to shift down and the equilibrium income (Y2) to be further
to the right. Where this line intersects with P2, the second point of the Aggregate demand
curve is drawn. This process could be repeated again to produce an even higher level of equilibrium
with lower prices. By connecting these points the downward sloping demand curve is formed.
Now for the reactions of the markets to a change in monetary policy. If the central
bank increases the money supply (M) the real money supply line shifts outward and the LM
curve shifts outward accordingly. Here is the LM curve being formed for M1,
a low supply of money. This forms the first point of equilibrium at i1 and Y1.
When the central bank increases the money supply to M2 the LM curve shifts down.
The immediate result is that the interest rate drops from its original equilibrium to
the intersection of Y1 and the lower LM curve. This is based on the assumption that the money
markets adjust quickly. At this point the money market is in balance because the point
is on the LM curve, but the interest rate is too low for the goods market to be in equilibrium.
At this position there is an excessive demand for goods so output and income start to increase.
The Money market adjusts quickly to the increased income: an increase in income increases the
demand for money and in turn increases the interest rate. This plays out as the point
of equilibrium moves up the LM curve until it reaches the IS curve. At this point the
interest rate and Income stabilize and the economy reaches equilibrium. So the end result
of the policy of increasing the money supply lower interest rates and a higher level of
national income.
Fiscal policy takes the form of government spending. The two red aggregate demand functions
contain exogenous demand, of which government spending is a factor. Here the IS curve is
derived using the first value of exogenous demand. Equilibrium income and interest rate
are found. By increasing government spending the red
aggregate demand curves are shifted upward. The resulting IS2 is shifted outward. The
money market quickly responds and a new point of equilibrium is reached at i2 and Y2. So
by increasing government spending, the equilibrium level of national income has risen and the
interest rate has also risen. That completes the video. Now you know how
to find equilibrium in the goods and money market, how to derive the Aggregate Demand
curve based on that equilibrium, how the economy responds in the short run to a change in fiscal
policy such as increasing the money supply or a change in monetary policy such as an
increase in government spending.
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