Topic 5 – Asset Markets & The IS-LM Model

1/ Introduction

In this note, we are going to provide a link between asset prices and the demand side of the economy. We will consider asset markets such as the stock market or house/ real estate markets and how the impact on aggregate demand. We will emphasize that agents are forward looking in terms of consumption and investment decisions which allows this link to be made.

In addition, if the government is funding spending through running a fiscal deficit, then the funding of this deficit will have implications for AD. If the government is running a deficit, it can fund this by either

  • Issuing bonds
  • Expanding the nominal money stock



Dt is the fiscal deficit at time t

Gt is government spending at time t

Tt is tax revenue at time t

Bt is the stock of bonds. Therefore ΔBt is the change in the stock of bonds between t and t-1.

Mst is the nominal money stock

Thus, if the public finances are initially in balance (i.e. Gt = Tt) and the government increases spending by £100m then it requires to finance this deficit and can do so in 2 ways

Increase the stock of bonds by ΔBt

Increase the nominal money stock by ΔMst

Note. If the increase in spending is permanent the state will require to find £100m each and every year. This implies either or both

A rising debt-GDP ratio

A rising nominal money stock

Note. If the government funds it’s deficit via bond sales, it will also require to raise additional capital to service the annual interest payments if it wishes to maintain a permanent nominal spend of £100m . Suppose r=10%. In year 2, the govt will require to raise not only £100m but also 10% of £100m. In total, the government needs to raise £110m in year 2 to maintain it’s deficit spend of £100m on public spending programmes. In year 3, the govt will require to raise £100m(1+r)2 = £100m (0.1)2 = £121m. In year t, the government would require to raise £100m(1+r)t-1. Clearly, if the government chooses to finance a deficit by continously issuing bonds, national debt will increase rapidly and problems will eventually arise in terms of servicing this.

2/  Wealth and the Goods Market

When deriving the IS curve, it is conventional to use a consumption function based on Keynes absolute income hypothesis. i.e. Ct = f(yt). This asserts that current consumption depends solely on current income. In economies with developed capital markets this is a poor description of consumer behaviour. A better approach is to assume that agents are ‘forward looking’ when making consumption decisions. Thus, in a 2 period context, we can write

Ct = g(yt, Et(Yt+1))

This states that current consumption depends on current income and expected future income. We can partition income into 2 broad classes

Labour income - yL

Unearned income - yU

Now, unearned income is the stream of future income from the ownership of assets such as equities, bonds and real estate. In properly functioning asset markets, the price of an asset, A, is the present value of the expected income stream,

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Thus, we can write our ‘forward looking’ consumption function as follows

Ct = g(ytL, Et(yt+1L), At)

This ‘life cycle’ model of consumers expenditure states that current consumption depends on current labour income, expected labour income and current (net) wealth. In addition,

Thus, a rise in current earned income increases current consumption as do rises in expected labour income or current (net) wealth. Figure 1 illustrates that, for the ‘short run’ consumption function, an increase in wealth from W0,t to W1,t engenders a rise in consumption from a given level of current earned income. A similar effect ...

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