Money and Banking
Money and Banking ECN 135
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This 4 page Class Notes was uploaded by Madie Schinner on Tuesday September 8, 2015. The Class Notes belongs to ECN 135 at University of California - Davis taught by Staff in Fall. Since its upload, it has received 22 views. For similar materials see /class/191902/ecn-135-university-of-california-davis in Economcs at University of California - Davis.
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Date Created: 09/08/15
University of CalifomiaDavis TA Jason Lee ECN l35Money and Banking Email jawleeucdavisedu Handout 6 I Review of ShortRun Macroeconomics We have introduced a basic model of aggregate demand in the previous section using the quantity equation MV PY see Ch 21 in text for this In actuality the derivation of aggregate demand is a little more complicated than that It is the interactions of two curves that allows us to trace the AD curve These two curves are IS InvestmentSavings Curve gt Relates to the GOODS MARKET MP Monetary Policy Curve gt Relates to the FINANCIAL MARKET Thus it is the ISMP Model that is the basis for Aggregate Demand Let us take a closer look at each of these curves To begin the analysis of the IS curve let s review something you should have seen in your ECN 1B class the Keynesian Cross Recall that the demand for goods and services is just C I G In the Keynesian Cross we call the demand for goods and services planned expenditures E ECIGNX You should know the following CCY T 1i GG NXNX5 Supply of goods and services is the amount of actual production Y As you might expect in equilibrium the demand for goods and services must equal the supply of goods and services In equilibrium Y Flamed Expenditure lt gt Y C I G NX Why must this be equilibrium Consider two cases Case 1 Y gt C I G NX In this case actual production is greater than demand for goods and services As a result inventories will start to build up T I This will signal to rms to produce less and start ring workers i Y This will continue until we reach Y C I G NX Case 2 Y lt C I G NX In this case demand for goods and services is greater than actual production As a result inventories will fall i I This will signal to rms that they need to produce more and hire more workers TY This will continue until we reachYC 1 G Figure 10 Keynesian Cross Equilibrium We plot the planned expenditure E on the Yaxis and the production Y on the xaxis There is a line of equilibrium points where Y E Equilibrium output is where the planned expenditure line intersects the YE line SHIFTS IN THE PLANNED EXPENDITURE CUR An upward shi in the expenditure curve Tl equilibrium output A downward shi in the expenditure curve ll LG TT will result in an increase in equilibrium output VE TG LT will result in an increase in Example Suppose there was an increase in government expenditures Ho ding l everything else constant an increase in G will shi the planned expenditure curve upward See Figure 11 A Figure 11 An increase in government expenditures panel 1 x 9V V 7 V W i Mi until now we have been assuming that investment I is determined exogenously In reality investment depends on the interest rate IIr The relationship between investment and the interest rate is negative A higher interest rate implies that the cost of borrowing is higher and this would reduce the level of investment With this relationship in place we are now ready to derive the InvestmentSavings IS IS CURVE The IS curve summarizes the relationship between the interest rate and the level of income The curve shows for any given interest rate the level of income that brings the goods market to equilibrium Figure 1 shows how we derive the IS Curve fl 11Fc1re 39 quot i 7C TCIH 39T 7 r M II x 7 r A ij 39 B39 s quot Y V W 1 Suppose we start with an interest rate of re At that given interest rate the goods market is in equilibrium at YD What happens if the interest rate suddenly decreases to r1 At a lower interest rate investment will increase This will shift the planned expenditure curve upward At the new equilibrium point output will be higher at Y1 Thus a lower interest rate implies a higher output We have thus derived the IS curve FISCAL POLICIES AND THE IS CURVE Any change in scal policies that increases planned expenditures will result in a rightward shi in the IS curve 0 Any change in scal policies that decreases planned expenditures will result in a le ward shift in the IS curve Figure 2 shows what happens to the IS curve when there is an increase in government expenditure Figure 2 Increase in G causes IS curve to shift to the right we 7 3 0 R r hur An increase in G results in an upward shi in the planned expenditure curve The new equilibnurn output Y is higher at the same level of interest rate As a result the IS curve shi s to the right MP Curve Recall that the Taylor Rule encapsulates Federal Reserve behavior is defined as Target Federal fund rate 25 current in ation 2in ation gap l2output gap Note that when determining the Federal funds interest rate the Federal reserve has two policy objectives two keep in ation in check and to make sure that output does not deviate too far from potential output 0 If in ation rises above its target level the response will be to raise interest rate Conversely if in ation falls below its target level the response will be to lower interest rate If output rises above potential output the response will be to raise interest rate Conversely if output falls below potential output the response will be to lower interest rate In general interest rates is determined by the following monetary policy reaction function r r7rY Here the equation is telling you that the target real interest rate is a function of the in ation rate and level of output they are both positively related We can draw the MP curve as showing the relationship between interest rate and output for a given level of in ation The MP curve is upward sloping Equilibrium in the lS MP model is de ned where the lS MP curve intersects This will give us the equilibrium interest rate and level of output
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