W5 Flashcards
equilibrium in the labor market leads to
employment at its full-employment level (N ̅) and output at its full-employment level (Y ̅).
Full-employment output = potential output = level of output when labor market is in equilibrium: Y ̅=AF(K, N ̅).
plot output against the real interest rate
we get a vertical line, since labor market equilibrium is unaffected by changes in the real interest rate
The full employment level of output is determined by
the full-employment level of employment and the current levels of capital and productivity.
→Any change in these variables shifts the FE line.
factors that shift the FE line
Goods Market Equilibrium:
S^d=Y-C^d-G
sd = id
what does the IS curve show
shows the real interest rate, r, for which the goods market is in equilibrium.
- shows the relationship between real interest rate and output for which investment = saving
why is the IS curve downward sloping
- At the higher level of output, the saving curve is shifted to the right compared to the situation at the lower level of output.
- Since the investment curve is downward sloping, equilibrium at the higher level of output has a lower real interest rate.
- Thus a higher level of output must lead to a lower real interest rate, so the IS curve slopes downward.
Alternative interpretation in terms of goods market equilibrium
- Beginning at a point of equilibrium, suppose the real interest rate rises.
- The increased real interest rate causes people to increase saving and thus reduce consumption (C), and causes firms to reduce investment (I).
- So the quantity of goods demanded (C + I) declines.
- To restore equilibrium, the quantity of goods supplied (Y) would have to decline
- So higher real interest rates are associated with lower output, that is, the IS curve slopes downward.
Factors that shift the IS curve
Asset Market Equilibrium
M/P=L(Y,r+π^e )
the real money supply (determined by CB equal the real quantity of money demanded.
goods market equilibrium condition determines r, this is true in the long-run when the economy is at full employment or all three markets are in equilibrium.
Asset market equilibrium determines the price level, P (this is true in the long run, when Y is at full employment).
asset market can affect the real interest rate in the short-run, why?
- relationship
Because if real money demand rises, people sell nonmonetary assets, so their prices fall – or equally, the real interest rates rise!
- for a given level of expected inflation, the price of a nonmonetary asset is inversely related to the real interest rate.
movements in the nominal interest rate are matched by equal movements in the real interest rate bc IR is constant
§Real money demand ______as the real interest rate rises.
§Real money demand ______ as the level of output rises.
falls
rises
The LM curve (Fig. 9.4) is derived by
real money demand for different levels of output and looking at the resulting equilibrium
LM curve slopes upward
· When Y increases real money demand increases – i.e. the demand curve for money shifts up and to the right.
· If the real interest rate did not change money demand would exceed money supplied.
· Excess for money forces individuals to sell-off their non-money assets (such as bonds). **
· The price of bonds decreases as the supply of bonds on the asset market increases.
· As the price of bonds is inversely related to their rate of return the nominal interest rate increases.
· With inflation held constant an increase in the nominal interest rate translates into an increase in the real interest rate.
· As the Interest rates increase, the demand for money declines until equilibrium is reached
factors that causes shifts in the LM curve
An increase in the real money supply shifts the LM curve _____ and to the ____
down, right
An increase in real money demand shifts the LM curve ____ and to the ____
up ; left
Applying the IS – LM framework: A temporary adverse supply shock
if A falls:
MPN falls, meaning labour demand falls (shifts left) so real wage and employment fall.
- lower employment and productivity means lower equilibrium level of output, so FE shifts to the left
NOW,
FE shifts to the left
- this means output has fallen**, so **lower income >> Sd falls
- so now, investment exceeds savings (goods market not in EQ)
- With investors wanting to borrow more than savers want to lend, so to fix this dis EQ, the “price” of funds—the real interest rate that lenders receive—will be bid up. (to increase Sd)
- this is why PRICE INCREASES TO SHIFT THE LM CURVE UP AND TO THE LEFT (real Md has fallen bc P increased)
- This restores general equilibrium, As a result, real interest rate is higher and output is lower, so consumption and investment fall (or a lower).
Effects of a monetary expansion
summary:
- real MS has increased (exp MP) and IR falls so LM shifts down and to the left
- when IR falls, COB is more flexible and saving is less favourable (Cd is higher Sd lower) so AD for goods rises
- Because aggregate demand exceeds full-employment output at point F, firms raise prices
→A 10% rise in P, from 100 to 110, restores the real money supply to its original level and shifts the LM curve back to its original position at 〖LM〗^1 . This returns the economy to point E, where output again is at its full-employment level of 1000, but the price level has risen 10% from 100 to 110.
