Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-1 CHAPTER 11 Extending the Sticky-Price Model: IS-LM, International Side, and

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.11-1

CHAPTER 11

Extending the Sticky-Price Model: IS-LM, International Side,

and AS-AD


Questions

• What is money-market equilibrium?• What is the LM curve?• What determines the equilibrium level

of real GDP when the central bank policy is to keep the money supply constant?

• What is the IS-LM framework?


Questions

• What is an IS shock?• What is an LM shock?• What is the relationship between

shifts in the equilibrium on the IS-LM diagram and changes in the real exchange rate?


Questions

• What is the relationship between shifts in the equilibrium on the IS-LM diagram and changes in the balance of trade?

• What is the aggregate supply curve?• What is the aggregate demand curve?


The Demand for Money• Three facts about business and

household demand for money– money demand is proportional to total

nominal income (PY)– money demand has a time trend, the

result of slow changes in the banking sector structure and technology

– money demand is inversely related to the nominal interest rate


The Demand for Money• Money demand is inversely related to

the nominal interest rate (i=r+) because the nominal interest rate is the opportunity cost of holding money– money balances lose purchasing power at

the rate of inflation ()– if money balances were placed in some

other asset, they would earn the prevailing market real interest rate (r)


The Demand for Money• To keep our model simple, we will

ignore the time trend in velocity• The demand for money can be

expressed as

• Money demand is proportional to real GDP and a decreasing function of the nominal interest rate

)(rVVY

PM

ei0

d


Money Market Equilibrium• In a sticky-price model, the price level

is predetermined– it cannot move instantly to make money

supply equal to money demand

• The nominal interest rate must adjust to keep the money market in equilibrium

i

0se

V

VM

P)(Y

)(ri


Figure 11.1 - Money Demand andMoney Supply


Money Market Equilibrium• If money supply < money demand

– businesses and households want to hold larger money balances and try to borrow to increase their cash holdings

– banks respond by raising interest rates– as the nominal interest rate rises, the

quantity of money demanded falls– this process continues until the quantity

of money demanded is equal to the money supply


Money Market Equilibrium• If money supply > money demand

– businesses and households are holding larger money balances than they want so they deposit them at the bank

– banks want to increase loans and thus respond by lowering interest rates

– as the nominal interest rate falls, the quantity of money demanded rises

– this process continues until the quantity of money demanded is equal to the money supply


The LM Curve• Because the demand for money

depends on the level of real GDP, if the money stock is constant, the equilibrium nominal interest rate will vary whenever real GDP varies


Figure 11.2 - Money Demand Varies as Total Income Y Varies


The LM Curve• The LM curve shows the relationship

between the level of real GDP and the equilibrium nominal interest rate that clears the money market

• The LM curve slopes upward– at a higher level of real GDP, money

demand is higher and therefore the equilibrium nominal interest rate is higher


Figure 11.3 - From Money Demand to theLM Curve


The LM Curve• The equation for the LM curve is

• Increases in the money supply shift the LM curve to the right• A decline in the price level shifts the LM curve to the right

PM

)](rV[VY ei0


The IS-LM Framework• As long as we know the expected

inflation rate, we can plot the IS and LM curves on the same axis

• The equilibrium levels of real GDP and the interest rate occur at the point where the IS and LM curves intersect– the economy is in equilibrium in both the

goods market and the money market


Figure 11.4 - The IS-LM Diagram


IS-LM Equilibrium• Example (assume that is constant at 3%)

– IS curve: Y = $10,000 - $20,000r– LM curve: Y = $1,000 + $100,000(r+)

3)$100,000(r$1,000$20,000r-$10,000

$120,000r$6,000

5%0.05r

billion $9,000Y


Figure 11.5 - IS-LM Equilibrium Example


IS Shocks• Any change in economic policy or the

economic environment that increases autonomous spending shifts the IS curve to the right– the new equilibrium will have a higher level

of real GDP and a higher real interest rate– how the total effect is divided between

increased interest rates and increased real GDP depends on the slope of the LM curve


Figure 11.6 - Effect of a Positive IS Shock


An IS Shock• Example

– initial IS curve: Y = $10,000 - $20,000r– LM curve: Y = $1000 + $100,000(r+3)– initial equilibrium: r=5%; Y = $9,000– autonomous spending increases– new IS curve: Y = $10,300 - $20,000r

3)$100,000(r$1,000$20,000r-$10,300

5.25%0.0525r

billion $9,250Y


Figure 11.7 - Calculating the Effect of anIS Shift


LM Shocks• An increase in the money stock will

shift the LM curve to the right– the new equilibrium position will have a

higher level of equilibrium real GDP and a lower interest rate


Figure 11.8 - Effect of an ExpansionaryLM Shock


An LM Shock• Example

– IS curve: Y = $10,000 - $20,000r– initial LM curve: Y=$1000+$100,000(r+3)– initial equilibrium: r=5%; Y=$9,000– the money supply increases– new LM curve: Y=$2200 + $100,000(r+3)

3)$100,000(r$2200$20,000r-$10,000

4%0.04r

billion $9,200Y


Figure 11.9 - An Expansionary Shift in theLM Curve


Interest Rate Targets• The case in which the central bank is

targeting the interest rate can be viewed in the IS-LM framework

• An interest rate target can be seen as a flat, horizontal LM curve at the target level of the interest rate


Figure 11.10 - IS-LM Framework with an Interest Rate Target


Changes that Affect theLM Curve

• Any change in the nominal money stock, in the price level, or in the trend velocity of money will shift the LM curve

• Any change in the interest sensitivity of money demand will change the slope of the LM curve



• The IS-LM diagram is drawn with the long-term, risky, real interest rate on the vertical axis

• The LM curve is a relationship between the short-run nominal interest rate and the level of real GDP at a fixed level of the money supply



• As long as the spread between the short-term, safe, nominal interest rate and the long-term, risky, real interest rate is constant, there are no complications in drawing the LM curve onto the same diagram as the IS curve



• If the expected rate of inflation, the risk premium, or the term premium between short- and long-term interest rates changes, the LM curve will shift– changes in financial market expectations

of future Federal Reserve policy, future interest rates, or changes in the risk tolerance of bond traders will shift the LM curve


Figure 11.11 - An Increase in Expected Inflation Moves the LM Curve Downward


Changes that Affect theIS Curve

• Shifts in the IS curve are more frequent than shifts in the LM curve

• Any change in the interest sensitivity of investment, the sensitivity of exports to the exchange rate, or the sensitivity of the exchange rate to the domestic interest rate will change the slope of the IS curve


Changes that Affect theIS Curve

• Anything that affects MPE will change the slope and the position of the IS curve– this includes changes in the MPC, tax

rates, and the propensity to import

• Any change in autonomous spending will shift the IS curve


The IS-LM Framework and the Exchange Rate

• In the sticky-price model, the real exchange rate () is equal to

)r-(r- fr0

• As long as the domestic real interest rate does not change, domestic conditions will have no impact on the exchange rate


The IS-LM Framework and the Exchange Rate

• Changes in the IS and LM curves that change the domestic real interest rate will alter the real exchange rate by an amount equal to (r r)– a rightward shift in the IS curve or a

leftward shift in the LM curve will lower the real exchange rate

– a leftward shift in the IS curve or a rightward shift in the LM curve will raise the real exchange rate


Figure 11.12 - IS-LM and the Exchange Rate


The IS-LM Framework and the Balance of Trade

• Changes in the domestic interest rate affect the real exchange rate which affects gross exports

• Changes in total income affect imports• The effect on net exports is the

difference between these two effectsIM-GXNX

Y)(IM-r)(NX yr


Figure 11.13 - Effect of a Change in Domestic Conditions on the Exchange Rate and the

Balance of Trade


An LM Shock and the Balance of Trade

• Example– initial IS curve: Y=$10,000 - $20,000r– initial LM curve: Y=$1000+$100,000(r+3)– initial equilibrium: r=5%; Y=$9,000– the money supply increases– new LM curve: Y=$2200+$100,000(r+3)– new equilibrium: r=4%; Y=$9,200


Figure 11.14 - Effects of Expansionary Monetary Policy


An LM Shock and the Balance of Trade

• Example (continued)– the decrease in the real interest rate

increases the exchange rate by [(-r r)= -10 (-.01)=0.10] and the rise in the real exchange rate increases gross exports by [(X )=$200 0.1=$20]

– the increase in real national income increases imports by [(IMy Y)=$0.15 $200=$30]

– net exports falls by $10


International Shocks• Three types of international shocks

will affect the IS-LM equilibrium– a shift in foreign demand for exports– a shift in the foreign real interest rate– a change in foreign exchange

speculators’ view about the fundamental value of the exchange rate


International Shocks• An increase in export demand is an

increase in autonomous spending (A0)– the IS curve shifts rightward by an

amount equal to A0/(1-MPS)

– equilibrium real GDP rises and the real interest rate rises as well (if the LM curve is upward sloping)


Figure 11.15 - Effect of an Increase in Foreign Demand for Exports


International Shocks• An increase in the foreign interest rate

raises the value of the exchange rate and boosts exports– the IS curve shifts to the right– equilibrium real GDP rises and the real

interest rate also increases (if the LM curve is upward sloping)


International Shocks• If foreign exchange speculators lose

confidence in their home currency, the exchange rate will rise– the IS curve will shift to the right– equilibrium real GDP will rise and the real

interest rate will increase (assuming that the LM curve is upward sloping)


International Shocks• Example

– LM curve: Y = $1000 + $100,000(r+3)– initial IS curve: Y = $10,000 - $20,000r– initial equilibrium: r=5%; Y= $9,000– foreign exchange speculators lose

confidence in the value of home currency– new IS curve: Y = $10,120 - $20,000r– new equilibrium: r=5.1%; Y = $9,100


Aggregate Demand• If the nominal money supply is fixed,

an increase in the price level shifts the LM curve to the left– the equilibrium real interest rate rises– the equilibrium level of real GDP falls

• If we plot the level of equilibrium real GDP for each possible price level, we will get the aggregate demand curve– it will be downward sloping


Figure 11.16 - An Increase in the Price Level Shifts the LM Curve Left (If the Nominal

Money Supply is Fixed)


Figure 11.17 - From the IS-LM Diagram to the Aggregate Demand Curve


Monetary Policy and Aggregate Demand

• Modern central banks alter the money supply in response to changes in the economy– when inflation rises, the central bank

tends to increase the real interest rate



• The Taylor rule is a simple model of how central banks act– the central bank has a target value of

inflation (’) and an estimate of what the normal real interest rate should be (r*)

– if inflation is higher than ’, the central bank raises the real interest rate

– if inflation is lower than ’, the central bank lowers the real interest rate



• The Taylor rule can be expressed in equation form:

)'-("*rr

• where ” determines how aggressively the central bank reacts to inflation



• The Taylor rule can be substituted into the equation for the IS curve

)'-(MPE-1

)X(I"*r

MPE-1XI

MPE-1A

Y rrrr0

)'-(' Y Y 0

• Simplifying, we get



• The monetary policy function is a relationship between the inflation rate and real GDP– it assumes that the Federal Reserve is

engaged in the economy trying to keep inflation close to its target

)'-(' Y Y 0


Figure 11.18 - The Monetary Policy Reaction Function


Aggregate Supply• When real GDP is greater than

potential output, inflation is likely to be higher than previously anticipated– inflation will like accelerate

• When real GDP is lower than potential output, inflation is likely to be lower than previously anticipated– the inflation rate will likely fall (may even

end up with deflation)


Aggregate Supply• The relationship between real GDP

(relative to potential output) and the rate of inflation (relative to its previously-expected value) is the short-run aggregate supply curve


Aggregate Supply• The short-run aggregate supply curve

can be expressed in equation form

e

e

PP-P

*Y*Y-Y

)-(*Y

*Y-Y e


Figure 11.19 - Output Relative to Potential and the Inflation Rate


Aggregate Supply and Aggregate Demand

• Where the aggregate supply and aggregate demand curves cross is the current level of real GDP and the current inflation rate


Figure 11.20 - Aggregate Supply and Aggregate Demand


Short-Run Aggregate Supply• High levels of real GDP are associated

with high inflation and a high price level for many reasons– when demand for products is stronger

than anticipated, firms raise their prices– when aggregate demand is higher than

potential output, some industries may reach the limits of capacity


Chapter Summary

• The money market is in equilibrium when the level of total incomes and of the short-term nominal interest rate is just right to make households and businesses want to hold all the real money balances that exist in the economy


Chapter Summary• When the central bank’s policy keeps

the money supply fixed--or when there is no central bank--the LM curve consists of those combinations of interest rates and real GDP levels at which money demand equals money supply


Chapter Summary• When the central bank’s policy keeps

the money supply fixed--or when there is no central bank--then the point at which the IS and LM curves cross determines the equilibrium level of real GDP and the interest rate


Chapter Summary• The IS-LM framework consists of two

equilibrium conditions– the IS curve shows those combinations of

interest rates and real GDP levels at which aggregate demand is equal to total production

– the LM curve shows those combinations of interest rates and real GDP levels at which money demand is equal to money supply


Chapter Summary• An IS shock is any shock to the level

of total spending as a function of the domestic real interest rate– an IS shock shifts the position of the IS

curve– an expansionary IS shock raises real GDP

and the real interest rate


Chapter Summary• An LM shock is a shock to money demand

or money supply– an LM shock shifts the position of the LM curve– an expansionary LM shock raises real GDP and

lowers the real interest rate


Chapter Summary• Anything that affects the level of the real

interest rate on the IS-LM diagram affects the real exchange rate– increases in the real interest rate reduce the value of

the real exchange rate, holding other things constant


Chapter Summary• A number of different international shocks can also

affect the real exchange rate– a collapse in foreign exchange speculator confidence in

the currency raises the real exchange rate– an increase in the real interest rate abroad also raises

the real exchange rate


Chapter Summary• The aggregate supply curve captures the

relationship between aggregate demand and the price level– the higher is real GDP, the higher the price

level and inflation rate are likely to be


Chapter Summary• The aggregate demand relationship arises because

changes in the price level and inflation rates cause shifts in the determinants of aggregate demand--either directly as changes in the price level change the money stock, or indirectly as changes in the inflation rate change the interest rate target of the central bank


Chapter Summary• Together, the aggregate demand and aggregate

supply curves make up the AS-AD framework, which allows us to analyze the impact of changes in economic policy and the economic environment not just on real GDP but also on the price level and the inflation rate as well

Documents

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-1 CHAPTER 11 Extending the Sticky-Price Model: IS-LM, International Side, and