Chapter 5: Goods & Financial MarketsBlanchard: Macroeconomics Slide #1 Goods & Financial Markets: The IS-LM Model The IS-LM Model The determination of

Chapter 5: Goods & Financial Markets Slide #1Blanchard: Macroeconomics

Goods & Financial Markets: The Goods & Financial Markets: The IS-LMIS-LM Model Model

The IS-LM ModelThe IS-LM Model

The determination of output andinterest rates in the short-run


Equilibrium in the goods market:Production (Y) = Demand (Z)

Or Investment = Saving “IS” Relation

Demand (Z)= C+I+GC=C(Y-T)T & G are given

Now let Investment depend on the level of sales (Y) and the interest rate (i):

The goods market and the IS relationThe goods market and the IS relation


),(

),(

iYII

),(

),(

iYII


The IS curveThe IS curve


),( iYII ),( iYII

GITYCY )( GITYCY )(

Equilibrium:

GiYITYCY ),()( GiYITYCY ),()(

Supply ofGoods

Demand forGoods (Z)

In the goods market, the higher the interest rate, the lower is investment and the lower is equilibrium output.

In the goods market, the higher the interest rate, the lower is investment and the lower is equilibrium output.


i

Y

IS (T)



Output, Y

Inte

rest

Rat

e, iShifts in the IS Curve:

IS´ (T´ > T)

Y´

An increase in taxes shifts the IS curve to the left


IS (G)

Y

i



Output, Y

Inte

rest

Rat

e, i

Y´

IS´ (G´ > G)

Shifts in the IS Curve:

An increase in G shifts the IS curve to the right


Shifts in the IS curveShifts in the IS curve

Goods & Financial Markets: The Goods & Financial Markets: The IS IS CurveCurve

What do you think:What do you think:

How would a decrease in consumer confidence shift the IS curve?How would a decrease in consumer confidence shift the IS curve?


Money market equilibrium:

Demand for liquidity (L) = Supply of Money (M)

Money market equilibrium:

Demand for liquidity (L) = Supply of Money (M)

Financial Markets and the Financial Markets and the LMLM Relation Relation

Equilibrium Interest Rate:

M=$YL(i)Equilibrium Interest Rate:

M=$YL(i)

M = nominal money supply (controlled by the Central Bank)

$YL(i) = Demand for money (function of nominal income and the interest rate)


Real money, real income, and the interest rateReal money, real income, and the interest rate


Real IncomeP

YY

$)(

Real Money Supply =Real Money Demand: Y(L)i

P

M

LM relation: iLYP

M)(


Md (for Y)

M/P

Ai

Ms

An increase in demand for real balances:An increase in demand for real balances:


(Real) Money, M/P

Inte

rest

Rat

e, i

Increase in Y => increases Md which increases i

Aí´

Md´ (for Y´ > Y)


A´

Md´ (for Y´ > Y)

LM (M/P)

A A

Y

ii

Md (for Y)

M/P

Ms

iÁ´

Y´

i´

The LM curveThe LM curve

Financial Markets and the Financial Markets and the LMLM Relation RelationIn

tere

st

Ra

te,

i

(Real) Money, M/P

Interest Rate, i

Income, Y


The LM curveThe LM curve


Shifts in the LM Curve: Showing changes in M & P

Inte

res

t R

ate

, i

(Real) Money, M/P

b

a

M/P

LM (M/P)Interest Rate, i

Income, Y

a

b

YÝ

i

i´

Md (for Y)

i

i´

Ms

Md´ (for Y´ > Y)

M´/P

LM´ (M´/P > M/P)

i´2

i2

i´2

i2

Ms´

a´

b´

a´

b´


Equilibrium Requires:Equilibrium Requires:

The The IS-LMIS-LM Model Exercises Model Exercises

GiYITYCYIS ),()(:

)(: iYLP

MLM

LMISor


The IS-LM Equilibrium GraphicallyThe IS-LM Equilibrium Graphically

The The IS-LMIS-LM Model Exercises Model Exercises

Output, Y

Inte

rest

Rat

e, i

IS

Y

i

LM

i & Y is the only interest rate, output combination that yields a simultaneous equilibrium in the goods and financial markets


Fiscal Policy, Activity, and the Interest RateFiscal Policy, Activity, and the Interest Rate

Question:Question: What impact will this fiscal contraction policy have on output and interest rates?

What shifts? IS, LM or both?

ANSWER: IS

What impact will this fiscal contraction policy have on output and interest rates?

What shifts? IS, LM or both?

ANSWER: IS

A Scenario:A Scenario: The President and Congress agree on a policy to reduce the budget deficit by increasing taxes, while holding gov’t spending constant.




Output, Y

Inte

rest

Rat

e, i

IS´ (T´ > T)

Y´

i´

LM

Y

iF A

IS (T)

• IS & LM: Before the tax increase Equilibrium A: i & Y

• IS´: After the tax increase

• Would the tax increase change LM?

• Disequilibrium at i (F, A) after tax increase

• i´, Y´ New equilibrium A´

• The fiscal contraction lowered interest and output

A´



Is deficit reduction good or bad for investment?

Interest rate falls good for investment

But

Output falls bad for investment

Is deficit reduction good or bad for investment?

Interest rate falls good for investment

But

Output falls bad for investment

Here’s one for the devil’s advocate…Here’s one for the devil’s advocate…


Monetary Policy, Activity, and the Interest RateMonetary Policy, Activity, and the Interest Rate

Question:Question: What impact will the monetary expansion have on output and interest?

What shifts? IS, LM, or both?

ANSWER: LM

What impact will the monetary expansion have on output and interest?

What shifts? IS, LM, or both?

ANSWER: LM

A Scenario:A Scenario: The Fed engages in monetary expansion, i.e., it increases the money supply through open market operations





Output, Y

Inte

rest

Rat

e, i

Y´

i´

LM (M/P)

Y

iA B

IS

A´

LM´ (M´/P > M/P)

• IS & LM: Before increasing M Equilibrium A: i & Y

• LM´: After increasing M

• Disequilibrium at i (A, B)

• New equilibrium A´: i´ & Y´

• Monetary expansion lowered i & increased Y


The effects of fiscal and monetary policyThe effects of fiscal and monetary policy

Fiscal Policy and Monetary Policy: Fiscal Policy and Monetary Policy: Activity and the Interest RateActivity and the Interest Rate

Shift in IS Shift in LM Movement in Output

Movement in Interest Rate

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


Using a Policy MixUsing a Policy Mix

Recall:Recall:Deficit reduction reduces output

Expansionary fiscal policy increases the deficit

Deficit reduction reduces output

Expansionary fiscal policy increases the deficit

The policy dilemma of 1992:

The policy dilemma of 1992:

Record high federal budget deficit (4.5% of GNP)

High unemployment and slow growth

The Clinton-Greenspan Policy MixThe Clinton-Greenspan Policy Mix

Solution: Policy MixSolution: Policy Mix

Deficit reduction and expansionary monetary policyDeficit reduction and expansionary monetary policy




Output, Y

Inte

rest

Rat

e, i

Y´

i´

LM

Y

i B

A

IS´

A´

LM´

• IS & LM: Before policy changes Equilibrium A: i & Y

• IS´: After deficit reduced

• B equilibrium without monetary expansion

• LM´ after monetary expansion

• New equilibrium i´, Y´ IS




Observations:Observations:

• Strong consumer confidence andstock market shifting IS from 1992to 1998

• The strong expansion automaticallyreduced the deficit (1% growth reducesthe deficit to GNP ratio by 0.5%)




The U.S. Economy 1991-1998The U.S. Economy 1991-1998

1991 1992 1993 1994 1995 1996 1997 1998

Budget surplus(% of GDP)(minus sign: deficit)

GDP growth (%)

Interest rate (%)

-3.3 -4.5 -3.8 -2.7 -2.4 -1.4 -0.3 -0.8

-0.9 2.7 2.3 3.4 2.0 2.7 3.9 3.7

7.3 5.5 3.7 3.3 5.0 5.6 5.2 4.8


Adding DynamicsAdding Dynamics

Observations:Observations:

•Changes in output adjust slowly to changes in the goods market (IS)

•Interest rates adjust instantaneously to changes in the financial markets (LM)


LM´


Dynamics GraphicallyDynamics Graphically

Inte

res

t R

ate

, i

Output, Y

A´

Ya

LM

Inte

res

t R

ate

, i

Output, Y

A

B

Ya

iA

IS´

iA

B

IS

Yb

Interest ratesadjust

instantaneously

Outputdecreases

slowly

Adjusting to atax increase

Adjusting to amonetary contraction

iB



The Dynamics of Monetary Contraction with IS-LMThe Dynamics of Monetary Contraction with IS-LM

Output, Y

Inte

rest

Rat

e, i

Y´

i´

LM

Y

iA

A´

IS

A´´

LM´

• A: Initial equilibrium (i & Y)

• LM´: After reducing money supply

• i rises to i´´

• Higher i reduces demand and output slowly A´´ to A´

• Equilibrium restored at A´: i´, Y´

i´´



A SummaryA Summary

•Monetary policy changes interest rates rapidly and output slowly

•The Central Bank must consider the output lag when implementing monetary policy

•Monetary policy changes interest rates rapidly and output slowly

•The Central Bank must consider the output lag when implementing monetary policy


Does the Does the IS-LMIS-LM Model Actually Capture What Model Actually Capture What Happens in the Economy?Happens in the Economy?

The Empirical Effects of an Increase in the FederalFunds RateThe Empirical Effects of an Increase in the FederalFunds Rate















The IS-LM model is consistent with economic observations

The IS-LM model explains movements in economic activity over the short-run

The IS-LM model is consistent with economic observations

The IS-LM model explains movements in economic activity over the short-run

SummarySummary

Documents

Chapter 5: Goods & Financial MarketsBlanchard: Macroeconomics Slide #1 Goods & Financial Markets: The IS-LM Model The IS-LM Model The determination of