wk8- is-lm model

• In the simple model we make the following assumptions: prices and wages are fixed, focus on the analysis is the short run not long run, model is comparative static in nature (we look at starting and end positions)
• IS schedule in a closed economy

  Shows different combinations of the rate of interest and level of national income for which the goods market is in equilibrium

  In closed economy with gov sector this occurs where I+G=S+T
• Assume I=I(r) so increase in r leads to fall in investment 

  Assume S=S(Y) so increase in national income leads to rise in savings

  Assume T=T(Y) so increase in national income leads to a rise in tax revenue 
• The elasticity of the IS curve depends on the responsiveness of investment and saving to interest rate changes ( the bigger the vertical shift in the I and S curves) and the size of the multiplier given by 1/mps, the mps is given by the slope of the s curve, the flatter the curve the bigger the multiplier (the larger the bigger the effect on national income of any rise in investment and dall in saving and more elastic).
• Keynesians argue that the IS curve is likely to be fairly inelastic (steep) as investment is not very responsive to changes in real interest rates. Also claim that savings is unresponsive to real interest rate changes. Monetarists by contrast argue that investment and saving are relatively responsive to changes in real interest rates.
• Factors which shift curve to the right: decrease autonomous savings, increase in gov expenditure, increase in investment expenditure, rise in business confidence at the current real interest rate 
• The MP curve 

  Relatively new model developed in context of inflation targeting central banks, no inflation target like the MP model 

  Assume the central bank has a single mandate: to target a given inflation rate, it adjusts the nominal policy rate (rate of interest it is prepared to supply liquidity to financial institutions which affects other interest rates in the economy).
• Assume people use the current rate of inflation (π) in forming expectations of real interest rate. The real rate of interest (r) is simply the nominal interest rate (i) less the current rate of inflation.
• The slope of the MP curve depends on the increase in the rate of inflation (the bigger increase the more raised interest rates so steeper MP), the weight the central bank places on stabilising inflation (more important the larger the increase in real interest rates hence steeper), central banks forecasts of how the transmission mechanism of monetary policy will affect inflation
• Elasticity-  depends on the degree of slack in the economy, if operating well below poteintial Y a rise in Y will have little effect on inflation. If there is a positive output gap with firms operating close to full capacity a rise in income will be reflected larger in a rise inflation
• Shift in MP curve- change in target rate of inflation (if raised curve will shift downwards), cost push inflation (if reduction curve shift downwards), change in potential national income (increase will reduce demand pull inflation pressures shifting curve downwards)
• LM schedule in a closed economy 

  In a closed economy assume money supply (Ms) is exogenously controlled by the central bank so can be changed via open market operations. When it comes to money demanded (Md) shall assume that there are two sources of money demanded: transactions demanded (Mt) and speculative demand (Msp) in equilibrium Ms=Md=Mt+Msp 
• Assume Mt=Mt(Y), transactions demand for money increase with national income 

  Assume Msp=Msp(r), speculative demand for money falls as rate of interest rises

  Slope dependant on: interest elasticity of the demand for money 

  Factors that shift to right: an increase in money supply, a decrease in price level 
• Impact of a fiscal expansion (increase in G) 

  Less than the case of the multiplier,  due to the rise in the in domestic interest rate which crowds out to some extent private sector investment leading to a less expansionary effect of the increased government expenditure 
• Limitations of IS-IM model

  Short run focus, ignores supply side effects, ignores expectations, ignores inflationary effects, usage of single interest rate, ignores time lags, ignores exchange rate effects and impact on capital flows