2-1

Lecture 1

Introduction to
Mathematical Economics
2-2

Consumers make Businesses make

Businesses make
buying decisions to hiring/capital
pricing decisions to
maximize utility investment decisions
maximize profits
to minimize costs

We need some
tools to analyze
these optimization
problems

Consumers make Consumers make

labor decisions to savings decisions to
maximize utility maximize utility
2-3
Relations among Economic Agents
goods/services
Financial in.
money

Inputs markets

Inter-
mediate firms
Govern- House-
holds
Goods ment
markets

Goods markets

National boundary

Foreign economies
2-4

Models and data

 Model
 a framework based on simplifying
assumptions
 helps to organize our economic thinking
 Data
 the economist’s link with the real world
 time series
 cross section
On Role of Models
2-5
 Economic models
 Fashion models
 Appreciation and dressing
 Understanding and solving
up prob
 Learn through fashion  Learn through classes.
shows, magazines, talks… books…
 Principles and examples
 Principles and examples
 Simple environment: not
needed  Simple system: not needed
 Modern metropolitan:  Complicated system: needed
needed  Almost not directly useful;
 Almost not directly useful
 entrepreneurship – through
 sophisticated tastes –
through learning life
 Taste and prepared for  Knowledge and prepared for
opportunities for jobs, opportunities for jobs, life
sexual
 A basis for sophisticated jobs
 A necessity for modern
in modern economies
sophisticated life
2-6

Diet problem
 To decide the quantities of different food
items to consume every day to meet the
daily requirement (DR) of several
nutrients at minimum cost.

6
2-7

Diet problem continued

 What decision variables do we need?
‣ Units of wheat consumed every day X
‣ Units of rye consumed every day Y

 What type of data do we need?

 What constraints do we need?

 What is our objective function?

7
2-8

Diet problem data

Wheat Rye DR

Carbs/unit 5 7 20

Proteins/unit 4 2 15

Vitamins/unit 2 1 3

Cost/unit 0.6 0.35

8
2-9

minimize 0.6X +0.35Y

subject to

5X + 7Y ≥ 20
4X + 2Y ≥ 15
2X + Y ≥ 3
X≥ 0
Y≥ 0

Optimal solution : X = 3.611 Y = 0.278

Cost : 2.2639

9
2-10

It’s Your Move

BY: Sarasota County Libraries (flickr)

http://creativecommons.org/licenses/by-nc-sa/2.0/deed.en
2-11

The IS schedule 1

Economy :

Y  C  I ; C  48  0.8Y ; I  98  75r ;
M s  250; M d  52  150r  0.3Y

Y : income; C : consumptio n; I : investment ;

r : rate of int erest
M s : money supply ; M d : money demand

IS curve : commodity equilibriu m

Y  C  I  0.2Y  75r  146  0
2-12

The LM schedule 1
LM curve : money demand  money supply
M s  M d  0.3Y  150r  198  0
2-13

Equilibrium in goods and money markets 1

IS curve : commodity equilibriu m

Y  C  I  0.2Y  75r  146  0
LM curve : money demand  money supply
M s  M d  0.3Y  150r  198  0

Market equilibrium: simultaneous equilibrium in the two markets

r  0.08, Y  700  C  608, I  92, M  250

The IS-LM
model

14
2-15

The model
 The IS-LM model was developed in
1937 by John R. Hicks in an
attempt to authentically interpret
the “General Theory of
Employment, Interest and Money”,
the famous book published by John
Maynard Keynes in 1936.

15
2-16

The model
 The model tries to explain the movement of
output and interest rate in the short run.
 To this end, it uses two curves: the IS (short
for Investment and Saving) and the LM (short
for Liquidity and Money).
 The IS curve represents equilibrium in the
goods market.
 The LM curve represents equilibrium in the
financial markets.

16
2-17

The IS curve
 We will try to use the goods market to
establish a relationship between the interest
rate and output.
 We already know [from introductory macro…]
that output in a closed economy is the sum of
consumption (C), investment (I) and
government expenditures (G).

Y = C + I + G

17
2-18

The IS curve (the Keynesian cross)

 We also know that output (Y) is by definition
equal to income and that it represents the
amount of spending undertaken by households,
firms and the government.
 But, how much do we want to spend? In other
words, what is our demand for goods and
services?
 If we denote demand with Z, then:
Z=C+I+G
 So, demand (like output) is simply equal to the
sum of consumption, investment and government
expenditures.
18
2-19

The IS curve (the Keynesian cross)

 If we try to elaborate a bit more on the form of
consumption, we can say that consumption
must depend on our disposable income.
 Our disposable income must be equal to total
income (Y) minus the taxes that we pay to the
government (T).
 So, consumption is a function of our
disposable income C(Y-T).

19
2-20

The IS curve (the Keynesian cross)

 What if we want to be more specific about the functional form of
the consumption function.
 Let’s assume that we must cosume something anyway in order
to survive, like food. We call this amount autonomous
consumption and let’s denote it by c0.
 The rest of our consumption depends on our disposable income
(Y-T). It is reasonable to assume that we consume a percentage
of our disposable income and that we save the rest of it. We call
this percentage marginal propensity to consume (MPC) and let’s
denote it by c1. Since we consume less than our disposable
income, c1 must be a number between 0 and 1. So, the non
autonomous part of consumption must look like that: c1(Y-T).
 Therefore, consumption in general must be equal to:
C = c0 + c1(Y-T)

20
2-21

The IS curve (the Keynesian cross)

 If this is the form of consumption, then demand in total must be
equal to:
Z = C + I + G =>
Z = c0 + c1(Y-T) + I + G =>
Z = (c0 - c1T + I + G) + c1Y
 This last equation tells us that demand is equal to a sum of some
variables that are exogenously given, namely:
c0 : the amount of autonomous consumption,
c1T: the amount of taxes times MPC,
I: investment, which for now we can assume that it is constant, and
G: government expenditures.
We will call this whole expression (c0 - c1T + I + G), autonomous
spending.
 It also tells us that demand is a positive function of income (Y) and,
moreover, that the slope of this positive function is c1, which is less
than one. So the slope of the demand is flatter than the 45o line (the
slope of which is 1).

21
2-22

The IS curve (the Keynesian cross)

 Now we have the first building block of the
Keynesian cross. We are going to graph the
demand as a function of income. We already
proved earlier that the demand is a positive
function of income and this is what we are
going to graph now.

22
2-23

The IS curve (the Keynesian cross)

Z
This is a picture of the demand
as a function of income. The
ZZ
vertical intercept of the line ZZ
which represents the demand, is
Slope: MPC the autonomous spending and
1$
its slope is the marginal
propensity to consume.

Vertical intercept:
autonomous
spending

23
2-24

The IS curve (the Keynesian cross)

 Our economy is in equilibrium when actual
production is equal to the demand, i.e. Y = Z.
 The only place that generally satisfies this
equilibrium condition is the 45o line in our
previous graph. So, our equilibrium must be
on that line.

24
2-25

The IS curve (the Keynesian cross)

 If we assume further, that there is no
inventory investment, then output (= income)
must always be equal to the demand.
 So, in that case, not only are we always on
the 45o line, but also always on the
intersection of the demand function with the
45o line, which is our equilibrium point.

25
2-26

The IS curve (the Keynesian cross)

Actual
Z Production This is a picture of the
Y=Z
Keynesian cross. We observe
ZZ
that in equilibrium, demand is
equal to income and production
Y* along the 45o line. In our model,
since there are no inventories,
we are always in equilibrium.

45o

Y* Y

26
2-27

The IS curve (the multiplier)

 If we combine the equilibrium condition Y = Z,
with the expression for the demand that we
derived earlier, Z = c0 + c1(Y-T) + I + G, we
get:
Y = c0 + c1(Y-T) + I + G =>
Y = c0 + c1Y - c1T + I + G =>
Y - c1Y = c0 - c1T + I + G =>
Y(1 - c1) = c0 - c1T + I + G =>
Y = [1/(1 - c1)] (c0 - c1T + I + G)

27
2-28

The IS curve (the multiplier)

 We have already called the (c0 - c1T + I + G)
part of the above equation, autonomous
spending.
 Now, we will give a name to the 1/(1 - c1) part
and we will call it the multiplier. The reason
for that name is that this fraction is greater
than one (remember that 0<c1<1).

28
2-29

The IS curve (the multiplier)

 Therefore, whatever the change is in any of
the parts of autonomous spending, the
change in output is a multiple of that change.
 So, if the government, e.g., decides to
increase G by an amount x, this will result in
an increase of Y by x times the multiplier.
 Graphically, the demand will shift up by as
much as the change in autonomous spending
(the vertical intercept) but output will increase
by more than that.

29
2-30

The IS curve (the multiplier)

 The size of the multiplier obviously depends on
c1, the marginal propensity to consume. The
larger the MPC, the smaller the denominator and
the larger the multiplier.
 Graphically, a large MPC corresponds to a
steeply sloped demand curve. Shifts of a steep
demand curve have large effects on income.
 A small MPC corresponds to a relatively flatter
demand curve. Shifts of a flatter demand curve
have relatively milder effects on income.
 We will now graph those two cases.

30
2-31

The IS curve (the multiplier)

The Keynesian cross The Keynesian cross
with a steep demand with a flat demand
(large MPC). The shift (small MPC). The shift
in demand has a large Actual in demand has a Actual
effect on output. Production milder effect on Production
Z Z output.
Y=Z ZZ2 Y=Z
Y2
ZZ1

ZZ2

Y1 Y2
ZZ1

Y1

45o 45o

Y1 Y2 Y Y1 Y2 Y

31
2-32

Deriving the IS curve

 The Keynesian cross is an important building
block toward the IS curve but our mission is
not accomplished yet.
 However, from this point the derivation of the
IS curve is straightforward. It relies on the
relaxation of an assumption that we made
earlier, namely that the level of investment is
constant.

32
2-33

Deriving the IS curve

 Constant investment is a clear simplification of the Keynesian
cross model. We already know that investment is not constant
but rather a negative function of the interest rate.
 At this point we also add that investment is also positively
related with output. The line of reasoning is that as firms see
their volume of sales going up, they will undertake more
investment to accommodate this increase. But the level of sales
is just proportional to output, since if output is increasing, more
goods are going to be sold and if output is decreasing less
goods are going to be sold. So, the bottom line is that we
observe a positive relationship between the level of investment
and the level of output.
 Therefore, investment is a negative function of the interest rate
and a positive function of output. In symbols we write:
I = I(Y,i)

33
2-34

Deriving the IS curve

 Focusing on the interest rate, we can say that
if the interest rate increases, this reduces the
level of investment, shifts down the demand
and consequently, through the multiplier,
reduces the level of income.
 On the other hand, if the interest rate
decreases, the level of investment increases,
the demand shifts up and the level of income
increases.

34
2-35

Deriving the IS curve

 We have therefore shown that there exists a
negative relationship between the interest rate
and income.
 This negative relationship is what is known as the
IS curve.
 The mathematical form of the IS curve is called the IS
relation and it is simply:
Y = C(Y-T) + I(Y,i) + G
 A more specific form of this equation is the already
familiar to us equation:
Y = [1/(1 - c1)] (c0 - c1T + I + G)
 This is the graphical derivation of the IS curve.

35
2-36

Deriving the IS curve Z Actual

A decrease in the interest rate Production
Y=Z
increases the level of investment ZZ2
(Panel A), which shifts up the Y2
demand and increases income Panel B
ZZ1
(Panel B). The IS curve sums up
these movements in the goods Y1
market (Panel C).
45o

Y1 Y2 Y
i i

i1
i1

Panel A Panel C
i2
i2 IS
I

I1 I2 I Y1 Y2 Y

36
2-37

Shifts of the IS curve

 As always in economics, here too
we are interested in curve shifts.
 So, we are going to mix things up a
bit, shift the curves around and see
what happens.

37
2-38

Shifts of the IS curve

 So, what could possibly move the IS curve?
 First, let’s recall the IS relation, Y = C(Y-T) + I(Y,i) + G,
the general equation that describes the IS curve.
 Which part of this equation could move the IS curve?
 Maybe, it’s better if we start by what could by no
means move the IS curve: income (Y) and the interest
rate (i).
 Why? Because, these are the endogenous variables of
our model. These are the variable that we are trying to
explain. They are the variables on the two axes of our
graph (like price and quantity in a supply and demand
diagram). So, if these two variables move, we move
along the curve. We don’t shift it.

38
2-39

Shifts of the IS curve

 So, what could move the IS curve is any of the other
variables that are exogenous, i.e. they are taken as given
outside the model, namely:
a) G, government expenditures (variable controlled by the
government),
b) T, taxes (variable controlled by the government),
c) C, consumption patterns that are independent of
disposable income, if for example, the households decide
to consume more because an asteroid is going to hit the
earth (variable controlled by household preferences), and
d) I, investment patterns that are independent of the interest
rate and income, if for example firms go into an
unexplained investing spree (variable controlled by the
animal spirits of the investors).
39
2-40

Shifts of the IS curve

 Out of those four parameters, we are mostly
interested in the first two (G and T), because it is
only those that policy makers can control. The
other two cannot be affected directly by
government policies.
 So, our analysis will be primarily focused on
government expenditures and taxes.
 However, just bear in mind that changes in
consumption and investment patterns affect the
IS curve in exactly the same way as changes in
government expenditures.

40
2-41

What happens if the government decides to

increase government expenditures (G↑)?

 We will use the Keynesian cross to explore the

effects of such a move.
 First, let’s recall the equation for the demand that
we derived earlier:
Z = (c0 - c1T + I + G) + c1Y
 If, ceteris paribus, the government decides to
increase G (by ΔG), then it is obvious that the
demand curve would shift up by an amount equal
to ΔG. The vertical intercept would move up by
ΔG but the slope would remain the same.

41
2-42

What happens if the government decides to

increase government expenditures (G↑)?

 But would happen to income after this shift of the

demand curve?
 Now, we have to recall the IS relation in the
specific form that we also mentioned earlier:
Y = [1/(1 - c1)] (c0 - c1T + I + G)
 If G↑, then Y would go up by as much as ΔG times
the multiplier 1/(1 - c1), so by more than ΔG.
 So, it looks like it’s a good deal for the government
to increase G, since with an initial amount of
increase, it can get income to increase more
through the multiplier.
42
2-43

What happens if the government decides to

increase government expenditures (G↑)?

 But, what does this mean for the IS curve?

 It means that the increase in government
expenditures caused an increase in income
for a given level of interest rate. Remember
that the interest rate did not move at all.
 This corresponds to a shift of the IS curve to
the right. For a given level of interest rate now
we have more income.
 Let’s look at this effect graphically.

43
2-44

The effects of G↑
Z Actual
Production
Y=Z
ZZ2
Y2
Panel A ΔG An initial increase in G shifts up
ZZ1
the demand by ΔG, which
increases income by ΔG/(1 - c1)
Y1 ΔY=ΔG[1/(1 - c1)]
in Panel A. This means that for a
45o
given level of interest rate, the
Y1 Y2 Y IS curve in Panel B must shift to
i
the right by ΔG/(1 - c1).
ΔY=ΔG[1/(1 - c1)]

Panel B i*

IS1 IS2

Y1 Y2 Y

44
2-45

What happens if the government decides to

decrease government expenditures (G↓)?

 The process that we follow must be clear by

now.
 Again we use the demand equation:
Z = (c0 - c1T + I + G) + c1Y
 If, ceteris paribus, the government decides to
decrease G (by ΔG), then it is obvious that
the demand curve would shift down by an
amount equal to ΔG. The vertical intercept
would move down by ΔG but the slope would
remain the same.

45
2-46

What happens if the government decides to

decrease government expenditures (G↓)?

 Then we use the IS relation to see what happens to

income:
Y = [1/(1 - c1)] (c0 - c1T + I + G)
 If G↓, then Y would go down by as much as ΔG
times the multiplier 1/(1 - c1), so by more than ΔG.
 This means that the decrease in government
expenditures caused a decrease in income for a
given level of interest rate.
 This corresponds to a shift of the IS curve to the
left. For a given level of interest rate now we have
less income.
46
2-47

The effects of G↓
Z Actual
Production
Y=Z
ZZ1
Y1
Panel A ΔG An initial decrease in G shifts
ZZ2
down the demand by ΔG, which
decreases income by ΔG/(1 - c1)
Y2 ΔY=ΔG[1/(1 - c1)]
in Panel A. This means that for a
45o
given level of interest rate, the
Y2 Y1 Y IS curve in Panel B must shift to
i
the left by ΔG/(1 - c1).
ΔY=ΔG[1/(1 - c1)]

Panel B i*

IS2 IS1

Y2 Y1 Y

47
2-48

What happens if the government decides to

decrease taxes (T↓)?

 Again we use the demand equation:

Z = (c0 - c1T + I + G) + c1Y
 If, ceteris paribus, the government decides to
decrease T by ΔT (so ΔT is negative), then it
is obvious that the demand curve would shift
up by an amount equal to -c1ΔT. The vertical
intercept would move up by -c1ΔT but the
slope would remain the same.

48
2-49

What happens if the government decides to

decrease taxes (T↓)?
 Then we use the IS relation to see what happens to
income:
Y = [1/(1 - c1)] (c0 - c1T + I + G)
 If T↓, then Y would go up by as much as ΔT times [-
c1/(1 - c1)].
 The expression [- c1/(1 - c1)] is the version of the
multiplier when taxes are changed by the government.
 We observe that in the numerator of this expression
there is c1, which corresponds to a number that is less
than one. Therefore, if we compare this version of the
multiplier with the general version [1/(1 - c1)], we
conclude that the general version is larger. This means
that expansionary fiscal policy is normally more
effective if conducted through increases in government
expenditures rather than decreases in taxation.
49
2-50

What happens if the government decides to

decrease taxes (T↓)?

 So, in effect the decrease in taxes

caused an increase in income for a
given level of interest rate.
 This corresponds to a shift of the IS
curve to the right. For a given level of
interest rate now we have more income.

50
2-51

The effects of T↓
Z Actual
Production
Y=Z
ZZ2
Y2 An initial decrease in T shifts up
Panel A -c1ΔT
ZZ1 the demand by -c1ΔT, which
increases income by
Y1 ΔY=ΔT[- c1/(1 - c1)] ΔT[- c1/(1 - c1)] in Panel A. This
45o means that for a given level of
Y1 Y2
interest rate, the IS curve in
i Y
Panel B must shift to the right by
ΔT[- c1/(1 - c1)].
ΔY=ΔT[- c1/(1 - c1)]

Panel B i*

IS1 IS2

Y1 Y2 Y

51
2-52

What happens if the government decides to

increase taxes (T↑)?

 Again we use the demand equation:

Z = (c0 - c1T + I + G) + c1Y
 If, ceteris paribus, the government decides to
increase T by ΔT (now ΔT is positive), then it
is obvious that the demand curve would shift
down by an amount equal to -c1ΔT. The
vertical intercept would move down by -c1ΔT
but the slope would remain the same.

52
2-53

What happens if the government decides to

increase taxes (T↑)?

 Then we use the IS relation to see what happens

to income:
Y = [1/(1 - c1)] (c0 - c1T + I + G)
 If T↑, then Y would go down by as much as ΔT
times [- c1/(1 - c1)].
 So, in effect the increase in taxes caused a
decrease in income for a given level of interest
rate.
 This corresponds to a shift of the IS curve to the
left. For a given level of interest rate now we
have less income.
53
2-54

The effects of T↑
Z Actual
Production
Y=Z
ZZ1
Y1
Panel A -c1ΔT An initial increase in T shifts
ZZ2 down the demand by -c1ΔT,
which decreases income by
Y2 ΔY=ΔT[- c1/(1 - c1)] ΔT[- c1/(1 - c1)] in Panel A. This
45o means that for a given level of
Y2 Y1 Y interest rate, the IS curve in
i
Panel B must shift to the left by
ΔT[- c1/(1 - c1)].
ΔY=ΔT[- c1/(1 - c1)]

Panel B i*

IS2 IS1

Y2 Y1 Y

54
2-55

To sum up IS shifts…
Initial
Shift of IS
Change
G↑ Right

G↓ Left

T↓ Right

T↑ Left

55
2-56

The LM curve
 To get to the LM curve, we have to use
financial markets and go through the theory
of liquidity preference. We have to
understand why people decide to hold money
in their pockets or in non- interest bearing
bank accounts (checking accounts). In other
words why we choose to forgo the interest
rate that the banks offer us when we hold
illiquid bank products (e.g. CDs, etc.).

56
2-57

The LM curve
 The answer is very simple: convenience and
security.
 It is true that having highly liquid assets, such
as cash or immediately available, through an
ATM, checking accounts makes our life
easier.
 Imagine if we had to go to the bank to
liquidate part of our investments every time
we needed to go to the grocery store. Also
having liquid assets provide us with a sense
of security, that we will, no matter what, have
some money immediately available in case
an emergency (or a new financial opportunity)
occurs. 57
2-58

The LM curve
 Since we have answered why, now we have
to answer how much money we hold.
 To answer this question, first we have to
define what is money.
 Generally, for our purposes money is cash
and checking (non interest bearing) bank
accounts. This is known as M1.
 There are also other measures of money but
we are not really interested in them.

58
2-59

The LM curve
 Then we have to come up with a measure of
money. We call the measure of money with
the interesting name: real money balances or
real money stock (M/P).
 To determine how much money we hold, as
always in economics, we will look for an
equilibrium.
 The equilibrium between the supply of real
money balances and the demand for real
money balances.

59
2-60

The LM curve (Money supply)

 The supply of real money balances is easy
because it is exogenously given. It is
controlled by the central bank through the
ways that we learned in introductory macro
(open market operations, discount rate,
required reserves ratio). So the supply is just
a number decided by the central bank and we
do not need to worry about it.

60
2-61

The LM curve (Money supply)

i
Since money supply (Ms) is
Ms independent of the interest rate,
it can be represented by a
vertical line. The amount of
money supplied only depends
on the decision of the central
bank and nothing else.

M/P

61
2-62

The LM curve (Money demand)

 The demand for real money balances is more complicated.
The amount of real money balances that we demand,
depends on what?
 Well, first it depends on income (Y). The more income in an
economy, the more transactions will occur and the more
money we will demand to effect these transactions. So, there
is a positive relationship between demand for real money
balances and income.
 But also, it depends on the interest rate. The higher the
interest rate on illiquid financial products (e.g. CDs), the less
money we will demand, since money pays no interest
whereas these illiquid products do. Because we do not want
to lose a lot of interest, as interest rates go up, we will hold
less and less real money balances. So, there is a negative
relationship between demand for real money balances and
interest rate.
62
2-63

The LM curve (Money demand)

 If we wanted to write down in symbols what
we just said in words, we would write this
expression for money demand:
(M/P)d = L(i,Y)
 Demand for real money balances is a
function L of the interest rate and income.
 Or, if we want to assume that money
demand is exactly proportional to the level
of income in an economy, we can even
more simply write:
(M/P)d = YL(i)
63
2-64

The LM curve (Money demand)

i
So, if we want to graph the
relationship between money
demand (Md) and the interest
rate, it must be represented by a
downward sloping curve. As we
just said, money demand
depends negatively on the
interest rate.

Md = YL(i)

M/P

64
2-65

The LM curve (Money supply and

money demand in equilibrium)
 So, now that we have all the pieces, we can equate money
demand and money supply and find the equilibrium in the
money market, i.e. the equilibrium amount of real money
balances in our economy and the equilibrium level of interest
rate.
 Mathematically:
Ms = Md =>
(M/P)s = (M/P)d =>
(M/P)s = YL(i)
 This expression is what is called the LM relation. It is the
mathematical representation of the LM curve.
 Note that for the purposes of these notes, the symbols Ms and
Md refer to real money supply and real money demand,
unless otherwise specified.

65
2-66

The LM curve (Money supply and

money demand in equilibrium)
i
Therefore in equilibrium if we
s
M equate money supply and
money demand, we get the
equilibrium level of real money
balances and the equilibrium
level of interest rate.
i*

Md = YL(i)

(M/P)*
M/P

66
2-67

Deriving the LM curve

 From here the crucial step in order to derive the
LM curve is to bring income (Y) into play.
 We have already said that money demand
depends positively on income.
 This means that for a given level of interest rate,
a higher income would result to a shift of the
money demand to the right. If income increases,
for a given level of interest rate, I engage in more
transactions and I demand more real money
balances.
 The picture is as follows:
67
2-68

Deriving the LM curve

i
So, we notice that a higher level
s
M of income (Y2 >Y1), by shifting
the money demand to the right,
i2
is associated with a higher level
of interest rate.

i1
Md = Y2L(i)

Md = Y1L(i)

(M/P)*
M/P

68
2-69

Deriving the LM curve

 Therefore we have proved that, through the
channel of financial markets and the liquidity
preference theory, there is a positive
relationship between the interest rate and
output.
 This positive relationship between interest
rate and output is represented by the LM
curve.

69
2-70

Deriving the LM curve

Panel A Panel B
In Panel A, a higher level of
i i income (Y2 >Y1) shifts the
Ms
LM money demand to the right
i2 and results in a higher level
i2
of interest rate. In Panel B,
Md = Y2L(i) the LM curve sums up this
i1 positive relationship between
i1
income and interest rate.
Md = Y1L(i)

(M/P)* Y1 Y2
M/P Y

70
2-71

Shifts of the LM curve

 Now we will explore what shifts the LM curve.
 To this end, we have to recall the LM relation,
(M/P)s = YL(i), the equation that describes the
LM curve.
 Starting again by what could by no means
move the LM curve, it is now very easy to
say: income (Y) and the interest rate (i).
Exactly like in the IS case, if these two
variables move, we move along the curve.
We don’t shift it.
71
2-72

Shifts of the LM curve

 So, what could move the LM curve is any of the other variables that are
exogenous, i.e. they are taken as given outside the model, namely:
a) Ms, the money supply controlled by the central bank (note that the
central bank controls the nominal money supply, but given that we can
assume constant prices, effectively the central bank can control the real
money supply),
b) P, the level of prices, and
c) Md, the demand for real money balances, BUT only to the extent that
this is affected by factors other than the interest rate and income. So, if
just like that, for some weird reason, we start demanding more or less
money for a given level of interest rate and income. E.g. because an
asteroid is going to hit the earth and we want to engage in more
transactions in the last days of our earthly existence, we increase our
demand for money.
 Since, out of those factors, the policy maker can directly control only
the money supply (case (a)) through monetary policy, we are mostly
interested in changes in this first factor. However, for reasons of
completeness, we will examine here the other two factors as well
(cases (b) and (c)).

72
2-73
What happens if the central bank decides to
increase the money supply (Ms↑)?

 If the central bank decides to increase the

money supply, this would certainly mean that
the interest rate would decrease.
 So, for a given level of income, now we would
have a lower level of interest rate.
 This necessarily means that the LM curve
must shift down.

73
2-74

The effects of Ms↑

Panel A Panel B
In Panel A, the increase in
i s
(M )1 s
(M )2 i money supply shifts the
money supply to the right
LM1 LM2 and results in a lower level
of interest rate. In Panel B,
i1 i1
the LM curve shifts down
since, for the same level of
i2 income, now we have a
Md = YL(i) i2 lower level of interest rate.

(M/P)1 (M/P)2 Y*
M/P Y

74
2-75
What happens if the central bank decides to
decrease the money supply (Ms↓)?

 If the central bank decides to decrease the

money supply, this would certainly mean that
the interest rate would increase.
 So, for a given level of income, now we would
have a higher level of interest rate.
 This necessarily means that the LM curve
must shift up.

75
2-76

The effects of Ms↓

Panel A Panel B
In Panel A, the decrease in
i s
(M )2 s
(M )1 i money supply shifts the
LM2
money supply to the left and
LM1 results in a higher level of
interest rate. In Panel B, the
i2 i2
LM curve shifts up since, for
the same level of income,
i1 now we have a higher level
Md = YL(i) i1 of interest rate.

(M/P)2 (M/P)1 Y*
M/P Y

76
2-77
What happens if the level of prices goes down
(P↓)?

 Since we are interested in real money balances,

a decrease in the level of prices effectively
means that the supply of real money (M/P)s
increases. The supply of real money balances
increases without the intervention of the central
bank but only due the price change.
 Therefore, because of the increase in money
supply, the interest rate decreases.
 So, for a given level of income, now we would
have a lower level of interest rate.
 This necessarily means that the LM curve must
shift down.

77
2-78

The effects of P↓

In Panel A, the decrease in

Panel A Panel B
prices (P2< P1) causes the
i (M/P1) s (M/P2) s i
money supply to increase
and shift to the right. This
LM1 LM2 results in a lower level of
interest rate. In Panel B, the
LM curve shifts down since,
i1 i1 for the same level of income,
now we have a lower level of
i2
Md = YL(i) i2 interest rate.

(M/P)1 (M/P)2 Y*
M/P Y

78
2-79

What happens if the level of prices goes up (P↑)?

 An increase in the level of prices effectively

means that the supply of real money (M/P)s
decreases. The supply of real money balances
decreases without the intervention of the central
bank but only due the price change.
 Therefore, because of the decrease in money
supply, the interest rate increases.
 So, for a given level of income, now we would
have a higher level of interest rate.
 This necessarily means that the LM curve must
shift up.

79
2-80

The effects of P↑

In Panel A, the increase in

Panel A Panel B
prices (P2>P1) causes the
i (M/P2) s (M/P1) s i
money supply to decrease
and shift to the left. This
LM2 LM1 results in a higher level of
interest rate. In Panel B, the
LM curve shifts up since, for
i2 i2 the same level of income,
now we have a higher level
i1
Md = YL(i) i1 of interest rate.

(M/P)2 (M/P)1 Y*
M/P Y

80
2-81

What happens if money demand decreases (Md↓)?

 If money demand decreases for a given level

of income and interest rate (i.e. the asteroid
case), then the money demand curve shifts to
the left. This results in a lower interest rate.
 So, for a given level of income, now we would
have a lower level of interest rate.
 This necessarily means that the LM curve
must shift down.

81
2-82

Effects of Md↓

Panel A Panel B
LM1 In Panel A, a decrease in the
i i demand for money shifts the
Ms LM2
money demand to the left
i1 and results in a lower level
i1
of interest rate. In Panel B,
(Md)1
the LM curve shifts down
i2 i2 since, for the same level of
income, now we have a
(Md)2 lower level of interest rate.

(M/P)* Y*
M/P Y

82
2-83
What happens if money demand increases
(Md↑)?

 If money demand increases for a given level

of income and interest rate (again the
asteroid case), then the money demand shifts
to the right. This results in a higher interest
rate.
 So, for a given level of income, now we would
have a higher level of interest rate.
 This necessarily means that the LM curve
must shift up.

83
2-84

Effects of Md↑

Panel A Panel B
LM2 In Panel A, an increase in
i i the demand for money shifts
Ms LM1
the money demand to the
i2 right and results in a higher
i2
level of interest rate. In
(Md)2
Panel B, the LM curve shifts
i1 up since, for the same level
i1
of income, now we have a
(Md)1 higher level of interest rate.

(M/P)* Y*
M/P Y

84
2-85

To sum up LM shifts…
Initial change Shift of LM
Ms↑ Down
Ms↓ Up
P↓ Down
P↑ Up
Md↓ Down
Md↑ Up

85
2-86

The IS-LM model in all its glory…

i
LM If we put the IS and the LM curves
together in a diagram we are able
to determine the equilibrium level
of output and interest rate in a
i* closed economy.

IS

Y* Y

86
2-87
So, what happens if we shift the curves
in the full scale model?

 Now it’s time to use our model to see what

happens when we use fiscal or monetary
policy in order to affect different macro
variables.
 We will examine in turn fiscal expansion and
contraction and monetary expansion and
contraction.

87
2-88

Fiscal expansion
 As we already know, a fiscal expansion is a
situation where the government increases
government expenditures (G) or reduces
taxes (T).
 As we have mentioned, this corresponds to a
shift of the IS curve to the right.
 The result is a higher a level of output and a
higher level of interest rate.

88
2-89

Fiscal expansion

LM If the government engages in a

fiscal expansion, the IS curve
shifts to the right. The LM stays
i2 B still. The equilibrium moves from A
to B indicating a higher level of
i1
output and a higher level of
A
interest rate.

IS1 IS2

Y1 Y2
Y

89
2-90

Fiscal expansion elaborated…

 Now, let’s ask ourselves why did this happen?
 The first move was made by the government that chose to
embark on a fiscal expansion (by raising G or cutting T).
What’s the result?
 Either way (G↑ or T↓), the demand (Z) increases and
therefore output (= income) increases (remember the
Keynesian cross). What’s next?
 The increase in income, through the LM relation,
increases the demand for money leading to a higher
interest rate (remember the money supply and demand
graph). What’s next?
 The higher interest rate, by reducing private investment,
reduces demand and output but not enough to offset the
positive effect of the fiscal expansion on them.

90
2-91

Fiscal expansion elaborated…

 So now, we have a clear picture of how all our variables
moved:
a) C: consumption is positively affected either the fiscal
expansion was effected by an increase in G or through a
reduction in T (disposable income increases in both cases).
b) I: the movement of investment is ambiguous because on the
one hand output went up and we know that this boosts I, but
on the other hand the interest rate increased and we also
know that this shrinks investment. So the net effect is
ambiguous.
c) G: government expenditures went up if the fiscal expansion
was effected by an increase in G or were unaffected if the
fiscal expansion was effected by a decrease in T.
d) T: taxes went down if the fiscal expansion was effected by a
decrease in T or were unaffected if the fiscal expansion was
effected by an increase in G.
91
2-92
Aggregate effects of a fiscal expansion
conducted by G↑

Y i C I G T

↑ ↑ ↑ ? ↑ 0

92
2-93
Aggregate effects of a fiscal expansion
conducted by T↓

Y i C I G T

↑ ↑ ↑ ? 0 ↓

93
2-94

Fiscal contraction
 As we already know, a fiscal contraction is a
situation where the government decreases
government expenditures (G) or increases
taxes (T).
 This corresponds to a shift of the IS curve to
the left.
 The result is a lower level of output and a
lower level of interest rate.

94
2-95

Fiscal contraction

LM If the government engages in a

fiscal contraction, the IS curve
shifts to the left. The LM stays
i1 A still. The equilibrium moves from A
to B indicating a lower level of
i2 B output and a lower level of
interest rate.

IS1
IS2

Y2 Y1
Y

95
2-96

Fiscal contraction elaborated…

 Now, let’s ask again ourselves why did this happen?
 The first move was made by the government that chose to
embark on a fiscal contraction (by reducing G or
increasing T). What’s the result?
 Either way (G↓ or T↑), the demand (Z) decreases and
therefore output (= income) decreases (remember the
Keynesian cross). What’s next?
 The decrease in income, through the LM relation,
decreases the demand for money leading to a lower
interest rate (remember the money supply and demand
graph). What’s next?
 The lower interest rate, by increasing private investment,
increases demand and output but not enough to offset the
negative effect of the fiscal expansion on them.

96
2-97

Fiscal contraction elaborated…

 So now, we have a clear picture of how all the variables
moved:
a) C: consumption is negatively affected either the fiscal
contraction was effected by a decrease in G or through an
increase in T (disposable income decreases in both cases).
b) I: the movement of investment is ambiguous because on the
one hand output went down and this decreases I, but on the
other hand the interest rate decreased and this boosts
investment. So the net effect is ambiguous.
c) G: government expenditures went down if the fiscal
contraction was effected by a decrease in G or were
unaffected if the fiscal contraction was effected by an increase
in T.
d) T: taxes went up if the fiscal expansion was effected by an
increase in T or were unaffected if the fiscal expansion was
effected by a decrease in G.
97
 Aggregate effects of a fiscal contraction
2-98

conducted by G↓

Y i C I G T

↓ ↓ ↓ ? ↓ 0

98
 Aggregate effects of a fiscal contraction
2-99

conducted by T↑

Y i C I G T

↓ ↓ ↓ ? 0 ↑

99
2-100

Monetary expansion
 We already know that a monetary expansion
is a situation where the central bank
increases the money supply.
 We also know that this shifts the LM curve
down.
 The result is a higher a level of output and a
lower level of interest rate.

100
2-101

Monetary expansion

i
LM1 LM2 If the central bank engages in a
monetary expansion, the LM
curve shifts down. The IS stays
A still. The equilibrium moves from A
i1
to B indicating a higher level of
i2 B output and a lower level of
interest rate.
IS

Y1 Y2 Y

101
2-102

Monetary expansion elaborated…

 Now we have to tell the story again.
 The first move was made by the central bank
that chose to expand the money supply. What’s
the result?
 By remembering the money supply and money
demand graph, we conclude that this leads to a
lower interest rate. What’s next?
 The lower interest rate in turn leads to higher
investment and thus, higher demand and
output (remember the Keynesian cross).

102
2-103

Monetary expansion elaborated…

 So now, we have a clear picture of how all our
variables moved:
a) C: consumption increases since income went up
and so our disposable income (Y-T) went up.
b) I: investment unambiguously increased because
we saw that the interest rate went down (this
increases investment) and also income went up
(this also increases investment). So a monetary
expansion gives a twofold boost to investment
(compare that to the fiscal expansion which had
an ambiguous effect on investment).
c) G: government expenditures are unchanged.
d) T: taxes are unchanged.

103
2-104

Aggregate effects of a monetary

expansion

Y i C I G T

↑ ↓ ↑ ↑ 0 0

104
2-105

Monetary contraction
 We already know that a monetary contraction
is a situation where the central bank
decreases the money supply.
 We also know that this shifts the LM curve up.
 The result is a lower level of output and a
higher level of interest rate.

105
2-106

Monetary contraction

i
LM2
LM1 If the central bank engages in a
monetary contraction, the LM
curve shifts up. The IS stays still.
B The equilibrium moves from A to
i2
B indicating a lower level of output
i1 A and a higher level of interest rate.

IS

Y2 Y1 Y

106
2-107

Monetary contraction elaborated…

 Let’s tell the story for one last time.
 The first move was made by the central bank
that chose to contract the money supply.
What’s the result?
 By remembering the money supply and money
demand graph, we conclude that this leads to a
higher interest rate. What’s next?
 The higher interest rate in turn leads to lower
investment and thus, lower demand and output
(remember the Keynesian cross).

107
2-108

Monetary contraction elaborated…

 So now, we have a clear picture of how all our
variables moved:
a) C: consumption decreases since income went
down and so our disposable income (Y-T) went
down.
b) I: investment unambiguously decreased because
we saw that the interest rate went up (this
decreases investment) and also income went
down (this also decreases investment). So a
monetary contraction gives a twofold blow to
investment.
c) G: government expenditures are unchanged.
d) T: taxes are unchanged.
108
2-109
Aggregate effects of a monetary
contraction

Y i C I G T

↓ ↑ ↓ ↓ 0 0

109