ECOS2002 Intermediate Macroeconomics
Week 6:
Christopher Gibbs
University of Sydney
Semester 1, 2021
Recap
• Goals for this section of the class:
1 Build IS/LM model
2 Expand it to AD/AS model
3 Expand further to IS-MP-AS model
Structure of the IS/LM model
Money Market
Goods Market
IS/LM
Structure of the IS/LM model
Money Market
Goods Market
IS/LM
E
rr
Y Y
MP
Structure of the IS/LM model
E
rr
Y Y
MP
D(r0; G0; T0)
r0
Y0
IS(G0; T0)
Structure of the IS/LM model
E
rr
Y Y
MP
D(r0; G0; T0)
r0
Y0
IS(G0; T0)
IS(G0; T0) =
| Y = | 1 1-C1 (C0 – C1T0 + G0 + I0 – I1r) |
Deriving the LM Curve
• The Money Market
– In this market we look at people’s liquidity preferences
– Do people hold money in cash, saving accounts, money
market, cd’s, bonds, other financial assets?
– To simplify, consider just two choices:
– One can hold money as M1 or one can hold bonds that pay
the nominal interest rate i.
Deriving the LM Curve
• The demand for money is based on:
– Prices
– Income
– Nominal interest rates.
– Money does not earn interest.
– The opportunity cost of holding money is the nominal
interest rate.
Deriving the LM Curve
• The demand for money
MP D = L(|z Y
(+)
; i
|z
(-)
) (1)
We can give it a linear form
MP D = L0Y – L1i (2)
Deriving the LM Curve
• Recall the IS/LM is graphed in (Y; r) space.
– Therefore, we need to link i to r.
i = r + πe (3)
Deriving the LM Curve
• Recall the IS/LM is graphed in (Y; r) space.
– Therefore, we need to link i to r.
i = r + πe (3)
MP D = L0Y – L1(r + πe) (4)
Deriving the LM Curve
• Finally, we assume supply of money is fixed.
MP S = MP (5)
• To solve, we set supply equal to demand
MP S = MP D (6)
Deriving the LM Curve
MP S = MP D
M P
= L0Y – L1(r + πe)
L1r = L0Y – L1πe – M
P
r =
L0
L1
Y – πe – M
L1P
) the LM Curve
Deriving the LM Curve
• The LM (Liquidity Money) curve – relating the real
interest rate, money, output.
• Deriving the LM curve in the graphs
1 Start with the money market graph
2 Note that i = r + πe.
3 Draw the (Y; r) graph
4 Pick an initial r0, MP¯ and Y0
5 Given r0 and Y0 draw in the money market graph.
6 Place initial point in (Y; r) space
7 Increase Y ) Y1 > Y0
8 Find how this changes the money graph
9 Plot new point in (Y; r) to form the LM curve
The IS/LM model
E
rr
Y Y
MP
D(r0; G0; T0)
r0
Y0
IS(G0; T0)
LM MP ; πe
r0
MD(Y0; πe)
MS
MP 0
Assessable Material
For MIDSEMESTER EXAM ends here!
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