Wednesday, December 14, 2011

Combining the Models: IS-LM

So now we have two seemingly unrelated markets that are both cleared by the same thing: the interest rate. The IS-LM model, developed by John Hicks in 1936, combines the two. The model relates the interest rate (r) to GDP (or income on a national level) (Y). The two functions are not supply and demand but a downward sloping function representing cominbations of Investment and Saving corresponding to each combination of (Y) and (r). It's downward sloping because as income increases, saving increases relative to investment leading to a lower interest rate. The upward-sloping function is the Liquidity-preference and Money supply function which is upward sloping with relation to income because as income grows, money-demand increases due to the fact that more money is required to carry out more transactions in a larger economy; this causes money demand to grow relative to money supply, causing rates to rise. Yes, this is potentially the most obtuse collection of concepts in macroeconomics and the most convuluted framework ever. It makes more sense to see it put together piece by piece, but I don't have the ability to make the graphs I need myself and Google has failed me yet again.
As you can see, IS and LM intersect at FE, or the Full Employment level of GDP. This graph represents an economy in equilbrium, where the central bank has set the money supply relative to money demand in such a way as to set the LM curve along the IS curve so as to reach full employment and stable prices. If the central bank were to contract the money supply, the LM curve would shift to the left along IS, resulting in a new Y below Y*; in other words, a recession. If the central bank expanded the money supply relative to money demand, LM would move to the right of the current IS-FE point; that would mean an equilibrium point on Y above the FE level, which is to say an inflationary gap.

This brings us to the price-level aspect of IS-LM, and then onto its implicaitons for Eurozone policy. I can hardly wait.

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