L2_ISLM

2012‐05‐01 1 The interaction between the  financial markets and the markets  for goods and servicesfor goods and services ch 4 and 5 (parts of 6) Y=C+I+G+X‐IM Z C0+I+G+X C+I+G+NX Y( )( ) ( )( ) ( )0101 010 11 1 TcXGIC mtc Y mIMXGItYTYcCY −+++•+−−= −++++−+= Y=C+I(r)+G+X‐IM expenditure C+I+G+NX income( )( ) ( )( ) ( )( ) mtc rd mtc TcXGICY mIMXGrdItYTYcCY +−−−+−− −+++= −++−++−+= Π Π 1111 1 1 1 010 1010 Higher interest rate reduces I  (and C) 2012‐05‐01 2 ZZ (r low) ZZ (r high) Y r Z High real interest rate: low level of investments YYrlY rh IS rh rl Low income: Low level of savings I=S IS shows the various combinations of interest rates and national income that can provide equilibrium on the markets for goods and services- Given the current level of the exogenousg components of aggregate demand X, G are independent of Y and r C, Im och I are endogenous, meaning they depend on Y and/or r. A change in an exogenous variable shifts the IS line. r0 r0 r1 r1G The same effect from changes in X, T0 and (C0) Note: SEK/foreign curr. X I ISlow G IShigh G r1 r0 X-Im Y d MPLA d ir r MPL dA MPL Y 11 1 1 1 −== −=The equation: Intercept slope 2012‐05‐01 3 Movement along the line shows changes in investment or consumption induced by changes in the real interest rate or the national income The slope of the line shows the interest rate sensitivity in investments (and consumption), and the marginal propensity to save, the marginal fraction of income spent on i t d ds d th f ti f i s i GDP th timported goods, and the fraction of an increase in GDP that are taken by the government as taxes. A rise in MPC makes the IS-line flatter, increased MPM makes it steaper, higher income taxes also makes it steaper. An increase in the interest rate sensivitivity turns the IS-line flatter. (Investigate by drawing and solving eqs) Y d MPLA d ir r MPL dA MPL Y 11 1 1 1 −== −= The equation: IS i1 i0 Intercept slope iΔ MPL dY 1=Δ The demand for money Keep liquidity in order to: • meet unforeseen expenditures • make planned expenditure • maximise the expected yield on total wealth 2012‐05‐01 4 Demand for money • Precautionary demand (history?) • Tansactionary M kTM dt = • Speculative (negatively correlated to nominal  interest rates) k PY M = hikYMM dp d −+= p 11 Drop the precautionary motive! )( )( iPYLM d − =The textbook: Assume L is as follows: il • likPYM PY likPYM PY ilkL d d −= ⎟⎠ ⎞⎜⎝ ⎛ −= •−= 2012‐05‐01 5 Y High GDP: Money demand increases Liquidity preference, M/P LP 13 i High interest rate: Swap to shares, bonds, real estate.. M/P MD bonds, real estate.. 14 i MDgivenYil ih demand for security (bonds) M/P Expected fall in interest rate: Less money – more bonds, shares.. 15 2012‐05‐01 6 i MS Financial turbulence: Escape to money M/P MD/LP 16 OMO in a simple model (monetary expansion) ¾ There is only money(liquidity) and bonds (not liquid but with  yield / interest rate). ¾ Demand for liquidty is proportional to Y and negatively correlated to i‐ ¾ The two financial markets clear at a certain interst rate,  i.  Th bli k t i t f (100) d b d F2: sid. 17 The public keeps a certain amount of money (100) and bonds (900). Liquidity rate: ¾ 100/(100+900)=1/10. ¾The central bank wants to lower the interest rate. HOW? Buy bonds from the market och pay by a  deposit on the sellers bank account ¾ The CB buys bonds worth 100 and pays 100 in ”money”. ¾ The public now own liquidity worth 200 but still have a total  wealth of 1000.  ¾ 200/1000 = 2/10, which is too much at the old i (at a given Y). ¾ They wish to reduce liquidity and the demand for bonds i F2: sid. 18 increases ¾ The price of bonds rises, PB, Which is equivalent to a decrease in  the interest rate, since ¾ i = (Price at maturity – PB)/ PB ¾ The high price (the lower interest rate) restores the equilibrium on the financial markets and the proportion of liquidity to total  wealth is unchanged. ”ceteris paribus”. 2012‐05‐01 7 i MS M/P MD 19 The balance sheet of non‐bank firms and housholds ”the public” assets liabilities Cash, Cu Deposits, D Bonds, B Shares,Real estate Loans MS=Cu+D 20 Banks A Reserves, R Deposits, D Shareholders’ equity L Utlåning Banks multiply money(liquidity) VP Public A L Sedlar & mynt, Cu Inlåning, D Obligationer Aktier,Fastigheter Lån i bank 21 Central bank cash, Cu + R Bank reserves Banks deposits Foreign reserves Loans to banks Securities 2012‐05‐01 8 Deposits, D Loans Reserves, R100 90 1090 81 981 73 73 8 10% 90% 100 deposited 73 766 66 59                   59  7 53                   53 6 …. 1000 100900 22 ”cash reduces the money multiplier” Assume:The rate of cash is 5% of total deposits. Bank reserves are 1% out of total deposits. The Central Bank adds 100 to the market: θ•(Cu+R) = Cu+D 23 RCu DCu + +=θ Divide all terms in the right hand side by ”D”( ) ( )C( ) ( )( ) ( )DRDCu D D D Cu + + 24 2012‐05‐01 9 Cu/D is 0,05, R/D is 0,01 according to the prior assumptions: 51705,1105,0 ==+ 5,17 06,001,005,0 ==+ The effect of 100 added will be 1750. Use of cash and bank reserves are ”leakages”, but cash is also liquidity! 25 LM ii MS LPhighY r ih k hi kP MY hikY P M −= −= Yl Yh M/PLPlowY rl LPY BD Price fall i i k h Δ• The various combinations of national income (Y) And interest rates that provides equilibrium on the financial markets given the current real money supply. Low Y, low transactional deamand for money calls for Low interest rate, which drives the financial investors to sell bonds (and othe securities) and keep a higher proportion of thier assets as money (High Price = Low Interest Rate) 2012‐05‐01 10 Change in the money supply shifts the LM-line LM0 ri MS0 LPhighY i ih MS1 LM1 Ylow Yhigh M/PLPlowY il P M k Y Δ=Δ 1 Putting the goods market and the financial market together. i LM ie ( ) hikY P M iiIXGimYCTtYYcY −= •−+++−−−= 10000 The unique set of i and Y that clears the real markets and the financial markets (given the level of ”A” and real MS) Y IS Ye A h kdMPLP M k d hMPL Y 1 1 11 + + + = M 11 A d k hMPLP M MPL kdh i 1 1 11 + + + = 2012‐05‐01 11 the fiscal policy multiplier Ahi A h kiMPL Y 1 1 1 Δ=Δ Δ + =Δ h kdMPLA Y d k hMPL 1 1 1 + =Δ Δ + ”A flat IS‐curve and a flat LM‐curve” ZZ (G1) ZZ (G0) Y i1 LM AD after crowding out Fiscal policy YYgY0 IS0 i0 IS1 Y1 c.o The monetary policy multiplier khMPLP M Y + =Δ Δ 1 k d MPLP + 1 Efficency is dependent on a flat IS‐curve, but financial investor’s should not speculate much and we need money to have a high velocity. 2012‐05‐01 12 LM0 ii MS0 i1 i0 MS1 LM1 Monetary policy multipier Y0 Y1 M/P LP IS ZZ (G1) ZZ (G0) Y Z LM LM To avoid crowding out the government can borrow in foreign currency or from the central bank Y YgY0 IS0 i1i0 IS1 LM1 The latter is regarded as ”criminal behaviour”. The multiplier will be 1/MPL