International financial market and korean economy keynesian framework in a closed economy

The Keynesian framework derives equilibrium conditions for the markets for goods, money, and labor, and synthesize them.  The bond market equilibrium is guaranteed by Walras’ law.  Walras’ law tells that the sum of excess demands across all the markets is equal to zero.  In other words, in an economy with n markets, equilibrium in (n1) markets guarantees that the other market is already in equilibrium

Outline (Based on B&J)

1 Markets in the Kyenesian world

The Goods Market and the /S Relation Financial Markets and the LM Relation Combining IS and LM Curves

Policy Simulations within the IS-LM Framework IS-LM and the Reality

Markets in the Keynesian World

O Today we will learn about the Keynesian Framework

(so called the IS-LM framework)

O Keynes considers that the following four types of markets in

the economy constitutes the aggregate economy

A Goods Market (demand side)

A Money Market (demand side, financial market)

A Bond Market (demand side, financial market)

A Labor Market (supply side)

Where Are We Headed for

O The Keynesian framework derives equilibrium conditions for

the markets for goods, money, and labor, and synthesize them

= The bond market equilibrium is guaranteed by Walras’

law

O Waltlras’ law tells that the sum of excess demands

across all the markets is equal to zero

O In other words, in an economy with n markets,

equilibrium in (n-1) markets guarantees that the other market is already in equilibrium

1 The Goods Market and the JS Relation

O Equilibrium in the goods market exists when production, Y,

is equal to the demand for goods, Z This condition is called

the /S relation

Y=Z Z=C+1+G

Oln a simple model, the interest rate did not affect the

demand for goods The equilibrium condition was given by:

Y=C(Y-T)+1+G

1 The Goods Market and the JS Relation

Investment, Sales, and the Interest Rate

Investment depends primarily on two factors:

= The level of aggregate income, equivalent with that of

sales, positively(+) related to investment

= The interest rate, an opportunity cost of investment, 1s

inversely(-) related to investment

I= I(Y,i)

(+ a,

1 The Goods Market and the JS Relation

“* For a given value of the interest rate i, aggregate demand

iS an increasing function of output, for two reasons:

= An increase in output leads to an increase in income and

also to an increase in disposable income

= An increase in output also leads to an increase in

investment.

1 The Goods Market and the JS Relation

Determining Output

Note two characteristics of the Aggregate Demand Z:

= So far it has been assumed that C and / are linear wrt Y

But in general Z is a curve rather than a line

= Z 1s drawn flatter than a 45-degree line because it’s

assumed that an increase in output leads to a less than

one-for-one increase in demand (Remind the Paradox of

Saving)

1 The Goods Market and the JS Relation

The demand for goods is an

increasing function of output

Equilibrium requires that the

demand for goods be equal to

output

(a) An increase in the interest “

rate decreases the demand

for goods at any level of

output, leading to a

decrease in the equilibrium ,

level of output Supa

(b) Equilibrium in the goods

market implies that an

increase in the interest rate

leads to a decrease in output ()

The IS curve is therefore

Shifts of the /S Curve

¢We have drawn the IS curve, taking as given the values of

taxes, 7, and government spending, G Changes in either T

or G will shift the ZS curve

-To summarize:

= Equilibrium in the goods market implies that an increase in the

interest rate leads to a decrease in output This relation is represented by the downward-sloping /S curve

= Changes in factors that decrease the demand for goods, given the

interest rate, shift the /S curve to the left Changes in factors that increase the demand for goods, given the interest rate, shift the /S curve to the right.

1 The Goods Market and the JS Relation

Shifts of the /S Curve

2 Financial Markets and the LM Relation

O The interest rate is determined by the equality of the supply

of and the demand for money:

M = $YL(i)

M = nominal money stock

$YL(i) = demand for money

/= nominal interest rate

O The equation M = $YL(i) gives a relation between

money, nominal income, and the interest rate

2 Financial Markets and the LM Relation

O The interest rate is determined by the equality of the supply

of and the demand for money:

M = $YL(i)

M = nominal money stock

$YL(i) = demand for money

/= nominal interest rate

O The equation M = $YL(i) gives a relation between

money, nominal income, and the interest rate

2 Financial Markets and the LM Relation

2 Financial Markets and the LM Relation

2 Financial Markets and the LM Relation

Deriving the LM Curve

s+ The plot 1n the right hand side of the previous slide

represents the equilibrium interest rate, 7, on the

vertical axis against income on the horizontal axis

> This relation between output and the interest rate

is represented by the upward sloping curve called

the LM curve

2 Financial Markets and the LM Relation

Shifts of the LM Curve

tor M/P)

xa

|

Y Income, Y

2 Financial Markets and the LM Relation

Shifts of the LM Curve

WM Equilibrium in financial markets implies that, for a

given real money supply, an increase in the level of

income, which increases the demand for money, leads to

an increase in the interest rate This relation is

represented by the upward- sloping LM curve

lM An increase in the money supply shifts the LM curve

down; a decrease in the money supply shifts the LM curve up

3 Combining IS and LM Curves

IS relation: Y = C(Y - T)+ I(Y,i)+ G

4 Policy Simulations within the IS-LM Framework

Fiscal Policy, Activity, and the Interest Rate

OFiscal contraction, or fiscal consolidation, refers

to fiscal policy that reduces the budget deficit

OAn increase in the deficit is called a fiscal

expansion

OT axes affect the /S curve, not the LM curve.

Fiscal Policy, Activity, and

the Interest Rate

Equilibrium in the goods market implies

that an increase in the interest rate

leads to a decrease in output This is

represented by the IS curve

Equilibrium in financial markets implies

that an increase in output leads to an

increase in the interest rate This is

represented by the LM curve Only at

point A, which is on both curves, are

both goods and financial markets in

Monetary Policy, Activity, and the Interest Rate

O Monetary contraction, or monetary tightening, refers to a

decrease in the money supply

O An increase in the money supply is called monetary

expansion

O Monetary policy does not affect the /S curve, only the LM

curve For example, an increase in the money supply shifts

the LM curve down

4 Policy Simulations within the IS-LM Framework

The Effects of Fiscal and Monetary Policy

Increase in taxes Left None Down Down

Decrease in taxes Right None Up Up

Increase in spending Right None Up Up

Decrease in spending Left None Down Down

Increase in money None Down Up Down

Decrease in money None Up Down Up

4 Policy Simulations within the IS-LM Framework

The combination of monetary and fiscal polices 1s

known as the monetary-fiscal policy mix, or simply,

the policy mix

Sometimes, the right mix is to use fiscal and monetary

policy in the same direction

Sometimes, the right mix is to use the two policies in

opposite directions—for example, combining a fiscal

contraction with a monetary expansion

5 IS-LM and the Reality

Introducing dynamics formally would be difficult, but we can

describe the basic mechanisms 1n words

= Consumers are likely to take some time to adjust their

consumption following a change 1n disposable income

= Firms are likely to take some time to adjust investment

spending following a change in their sales

= Firms are likely to take some time to adjust investment

spending following a change in the interest rate

= Firms are likely to take some time to adjust production

following a change in their sales.

funds rate leads to a

decrease in output and

to an increase in

unemployment, but it has

little effect on the price

0.09

0.06 - 0.03 0.00

Effect of 1% increase

in federal funds rate

on the unemployment rate