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This chapter combines the theory of income and output and the theory of money and interest in a twomarket equilibrium model that shows how the goods and money markets interact to determine the levei of output and the rate of interest. The price level is not a variable in this model because the model retains the assumptions of Part 2: The aggregate supply curve is perfectly elastic up to the full employment level of output and does not shift; and the economys level of output varies along the range oeic.v the full employment level. Therefore, changes in aggregate spending can affect only the output level; the price level is fixed. The first part of the chapter explains the derivation of the IS and LM functions on which the model is built. At the particular combination of income level and interest rate at which IS equals LM, there is equilibrium in both the goods and the money markets. The /S and LM functions have long been the most basic tools of macroeconomics. The balance of the chapter uses them to examine questions that could not be handled adequately with the tools at hand in earlier chap ters. Following, the derivation of the IS and LM functions is the derivation of the aggregate demana function or curve. This is found from the intersection formed by the IS and LM functions. To simplify in this chapter, the assumptions are such as to produce a perfectly inelastic aggregate demand curve. The Extended Model: Fixed Price Level

The next part of the chapter analyzes the j arate and combined effects of increases in Ir ment and the money supply on the income and the interest rate. The conclusions re through the use of the JS-LM tool differ those reached when the goods and aspects of the analysis were considered rately. For example, the simple Keynesian pliers developed for the two-sector econ Chapters are now seen to apply only events in the monetary sector are such that! interest rate remains constant as agg spending for goods and services changes The same sort of general analysis is out in the next part




of the chapter for cha government spending and taxation. Here the simple government spending and tax pliers present- 6 in Chapter 6 are found tc only when the monetary authority acts to i a constant interest rate. last part of the chapter turns to the ques- fc - of the elasticities of the IS and LM functions, 5r<d .o the closely related question of the effec- *'* i^ess of monetary and fiscal policies. The elas- : ties of the two functions are analyzed to clarify re cifference between the extreme version of the : ;;s;cal theory which argues that only mone- policy can be effective in raising the income eeland the extreme version of the Keynesian

turn will discourage -. estment, and the actual rise in the equilibrium evel of income will be less thao it would other se be. Similarly, in developing the theory of -toney and interest in Chapter 11, we saw that a" increase in the money supply would reduce :ne interest rate, as shown by the movement down the given demand curve for money. How- ever, this curve assumed a given level of income. : we nOw admit the income level as a variable in the system, the increase in the money supply will, by lowering the interest rate, stimulate investment spending and raise the level of income. This will "crease the t:ansactions demand for money, and the actual fall in the interest rate will be less :nan it would otherwise be. Therefore, it appears theorywhich argues that only fiscal policy can be effective. On the basis of this analysis, the L/W function, if it is assumed to vary from porfect inelasticity at one extreme to perfect elasticity at the other, can be divided into a segment consistent with classical theory, a segment consistent with Keynesian theory, and an intermediate segment lying between the extreme versions of the two theories.

n previous chapters, we developed separately the theories of income determination and money and interest. Although this procedure provided an orderly introduction to the 'eevant theory, it must now be recognized as ghly simplistic. The two parts are actually so -e aed that what happens in one depends on nat happens in the other. In developing the sim- : s Keynesian theory of income determination in I-apters 4-7, we found that a rise in investment spending would raise the equilibrium level of "come by an amount.equal to the multiplier ~es the rise in investment spending. However,

that the interest rate and the level of income are linked in a complicated manner. In this and the following two chapters, we will construct and employ an extended model that can accommodate this and other complications.1 The Goods Market and the

implicitly assumed that the interest rate was z -en. If we now admit the interest rate as a var- icse in the system, the rise in investment spendg will, by raising the level of income, also force _ d the interest rate. This in



Money Market_________________ Our model consists of two parts: The first draws together the determinants of equilibrium in the market for goods, and the second draws together the determinants of equilibrium in the market for money. For a two-sector economy, we found in Chapter 4 that goods market equilibrium is found at that level of Y at which the sum of C + I is just equai to that level of Y. Goods market equilibrium is aiso defined by an equality between saving 'The construction here will be almost entirely' graphic. For an algebraic formulation of the same elementary model covered .in this chapter, see the Appendix to Chapter 12 of E. Shapiro, Macroeconomic AnalysisA Student Workbook, 5th ed.. Harcourt Brace Jovancvich, 1982. A concise algebraic treatment of a less elementary IS-LM model is provided in W.L. Smith and R.L. Teigen, Readings in Money, National Income, and Stabilization Policy, 4th ed., Irwin, 1978, pp. 1-22. The model, including a variable pries level, is developed in R.S. Holbroo*. "The Interest Rate, Price Level, and Aggregate Output, in the same volume, pp. 3KW5A