Goods and Financial Market

Equilibrium
Goods and financial markets equilibrium: The
IS-LM model
• Aim: To develop a framework to think about how output and the
interest rate are determined in the short run

• IS-LM framework
• Developed by John Hicks (1937) and extended by Alvin Hansen (1940s)
• Based on John Maynard Keynes’ (General Theory,1936) contribution: Joint
description of goods and financial market
• Till then: classical dichotomy- real v/s nominal variables ( real variables are
not affected by changes in nominal variables)
Quick Revision
• Goods market equilibrium
Production/Income (Y)= Demand (i.e. C,I, G)
𝑌ത =c0 + c1 (𝑌ത - 𝑇ത )+I(r)+ 𝐺ҧ
𝑌ത − (c0 + c1 (𝑌ത - 𝑇ത ))- 𝐺ҧ =I(r)
𝑆ҧ =I(r)
Goods market : Multiplier effect
• Goods market equilibrium (with the assumption investment is fixed
for short run)
Autonomous spending
• Autonomous spending:
It is the part of the demand for goods that does not depend on output.
For this reason, it is called autonomous spending.
As are positive; autonomous spending can be positive or
negative depending on the G and T; i.e depending on fiscal policy.
• Balanced budget:
Hence autonomous spending is positive in this case.
• Budget Surplus: if taxes were much larger than government
spending— autonomous spending could be negative
Multiplier
• In the equilibrium
• Multiplier:
• Because the propensity to consume c1 is between zero and 1; the
multiplier is a number greater than 1
• This term multiplies autonomous spending ; hence the name
multiplier. The closer c1 (i.e. MPC-marginal propensity to consume) to
1; the larger the multiplier
• 𝑐1 = 0.6;
• Then multiplier = 1/1- 𝑐1 = 2.5
• Hence Output Y= 2.5 * autonomous spending

Eg: if autonomous consumption increases by 1 million then

∆𝑌 = 2.5 ∗ ∆𝐶0 = 2.5* 1 million=2.5 million
Multiplier effect
• Multiplier implies that any change in autonomous spending (which
includes autonomous consumption, investment, taxes and government
spending) will change output by more than its direct effect on autonomous
spending.
• An increase in any autonomous spending has more than one for one effect
on equilibrium output.
• What causes multiplier effect?
An increase in autonomous spending (eg: autonomous consumption, C0)
increases the demand. The increase in demand then leads to an increase in
production. The increase in production leads to an equivalent increase in
income (as the two are identically equal). The increase in income further
increases consumption/spending, which further increases demand, and so
on.
Equilibrium in the goods market
Keynesian cross: goods market equilibrium
Multiplier effect from increase in autonomous
spending
Multiplier effect from fiscal policy
• Government purchase multiplier
1 ∆𝑌 1
∆𝑌 = ∗ ∆𝐺 ; =
1−𝑐1 ∆𝐺 1−𝑐1

• An increase in government purchases leads to an even greater increase in

income. That is, ΔY is larger than ΔG.
• When an increase in government purchases raises income, it also raises
consumption, which further raises income, which further raises consumption,
and so on. Therefore, an increase in government purchases causes a greater
increase in income.
• The ratio ΔY/ΔG is called the government-purchases multiplier; it tells us how
much income rises in response to a Rs.1 increase in government purchases.
• Since MPC is less than 1; government purchase multiplier is larger than 1
Govt. purchase multiplier
Multiplier effect from fiscal policy
• Tax multiplier
1 ∆𝑌 −𝑐1
∆𝑌 = ∗ −𝑐1 ∆𝑇 ; =
1−𝑐1 ∆𝑇 1−𝑐1

∆𝑌
Tax multiplier ( ) is the amount income changes in response to a Rs1 change
∆𝑇
in taxes. The negative sign indicates that income moves in the opposite
direction from taxes.
For example, if the marginal propensity to consume is 0.6, then the tax
multiplier is ΔY/ΔT=−0.6/(1−0.6)=−1.5.
In this example, a Rs.1 cut in taxes raises equilibrium income by Rs1.50 and vice
versa
Multiplier effect from investment
1 ∆𝑌 1
• ∆𝑌 = ∗ ∆𝐼 ; =
1−𝑐1 ∆𝐼 1−𝑐1
Investment and interest rates
• Another significant macroeconomic relationship is that planned
investment (demand for investment) depends on the interest rate r.

• I= I(r)
• As interest rate is the cost of borrowing to finance investment ; an
increase in interest rate reduces planned investment (or demand for
investment). As a result the investment function slopes downwards
Revision: S=I (loanable fund market)

• Saving is the supply of loanable fund

Households lend their saving to
investors or deposit their saving in a
bank that then loans the funds out
• Investment is the demand for loanable
funds:
• investors borrow from the public
directly by selling bonds or
indirectly by borrowing from
banks.
IS relation
• How income/output changes when interest rate changes?
IS relation
IS relation
IS curve
• The IS curve plots the relationship between the interest rate and the level
of income that arises in the market for goods and services. Generally, G and
T is assumed to be constant in the construction of IS curve.
• The IS curve shows us, for any given interest rate, the level of income that
brings the goods market into equilibrium. Each point on the IS curve
represents equilibrium in the goods market.
• In essence, the IS curve combines the interaction between r and I
expressed by the investment function and the interaction between I and Y
demonstrated by the Keynesian cross.
• The curve shows how equilibrium income depends on the interest rate.
Because an increase in the interest rate causes planned investment to fall,
which in turn causes income to fall, the IS curve slopes downward
Fiscal policy and
IS curve
• The Keynesian cross to show
how an increase in
government purchases ΔG
shifts the IS curve.
• This figure is drawn for a given
interest rate r¯ and thus for a
given level of planned
(demand for) investment.
• The Keynesian cross in panel
(a) shows that this change in
fiscal policy raises planned
expenditure and thereby
increases equilibrium income
from Y1 to Y2. Therefore, in
panel (b), the increase in
government purchases shifts
the IS curve outward.
Shifts in IS curve
• We can use the Keynesian cross to see how other changes in fiscal
policy shift the IS curve.
• Because a decrease in taxes also expands expenditure and income, it
shifts the IS curve outward as well.
• A decrease in government purchases or an increase in taxes reduces
income; therefore, such a change in fiscal policy shifts the IS curve
inward
Summary
• The IS curve shows the combinations of the interest rate and income
that are consistent with equilibrium in the market for goods and
services.
• The IS curve is drawn for a given fiscal policy. Changes in fiscal policy
that raise the demand for goods and services shift the IS curve to the
right. Changes in fiscal policy that reduce the demand for goods and
services shift the IS curve to the left