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What Can an Abstract Macroeconomic Model, Such as the IS-LM Model, Tell us about the Links between Financial and Real Production activity in an Economy?

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Introduction

WHAT CAN AN ABSTRACT MACROECONOMIC MODEL, SUCH AS THE IS-LM MODEL, TELL US ABOUT THE LINKS BETWEEN FINANCIAL AND REAL PRODUCTION ACTIVITY IN AN ECONOMY? WHAT ARE THE RANGE OF FINANCIAL INTERMEDIARIES EXISTING IN THE UK AND WHAT ARE THE BENEFITS OF FINANCIAL INTERMEDIARIES? The IS-LM model is a theoretical construct that integrates the real I-S (investment- saving), and the monetary, L-M (demand for and supply of money), sides of the economy simultaneously, to present a determinate general equilibrium position for the economy as a whole. In the IS-LM model, saving is a function of the level of national income and investment is a function of the interest rate, and marginal efficiency of capital and investment. The I-S schedule illustrates the set of different combinations of national income and interest rates where the equilibrium condition for the real economy I=S holds. Figure 11 From the figures above, at an interest rate of r , we know the level of investment demand and autonomous consumption demand, therefore, we know the height of the aggregate demand schedule, AD in figure (a). E indicates the equilibrium output in both, figures (a) and (b) . We can see that the goods market is in equilibrium, E as the interest rate is at r and national income is at y . Now if we imagine a lower interest rate of r , since investment demand will now be higher and the consumption function will have shifted upwards. ...read more.

Middle

As before, this process continues until interest rates rise to r* and income rises to Y*, and both markets are in equilibrium. The IS-LM model can be used to illustrate how fiscal policy and monetary policy can be employed to alter the level of national income. If the economy starts at equilibrium, E , an increase in the money supply, shifts the LM schedule to the right, LM , resulting in a rise in national income and a fall in interest rates. Figure 46 The initial position, E , is at the intersection of the IS schedule and the LM schedule. The resulting increase in expenditures, (which is caused by low interest rates and associated with higher investment), would, through the multiplier effect7, tend to lead to national income of Y . An excess demand for final output will also lead to an increase in goods prices. As prices rise, the real money supply falls and there are also effects due to a rise in relative price of domestic goods. These shift the IS and LM schedules back slightly to the left to a point A. (The shifted curves are not shown because they are so close to IS and LM ). Now, we can observe the effect of a fiscal policy expansion. Once again, the economy starts at full equilibrium, E , where interest rates are at r* and national income is at Y*. ...read more.

Conclusion

once, depositors can have access to their funds, even though the majority of funds have been lent for a long period of time. The advantage to the borrower is the availability of long-term loans, even though, perhaps, no one wishes to lend for a long period. This is known as maturity transformation. A benefit for lenders is that the institutions can pool lots of small deposits which taken separately would be unattractive to borrowers. These deposits can earn a rate of interest from being lent, which would not have been possible before. This is a plus-point for borrowers as they can borrow large sums of money, even though lenders may not wish to lend large sums. By operating on a large scale, the financial intermediaries can reduce risk for both parties by incurring the risk themselves. Institutions also reduce risk by their ability to diversify. They can do this by lending to a wide variety of people and organisations in such a way that an adverse event is likely to effect only a small proportion of loans. They can also diversify their sources of funds, so that a difficulty in raising funds from one source can be offset from elsewhere. "Diversification is one of the characteristics of financial intermediaries that tends to benefit from economies of scale."11 To put the role of financial intermediaries in simple terms, is to say that, intermediaries are making funds available (to lenders and borrowers) cheaply, readily and with a minimum of risk. ...read more.

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