Prepared by: Fernando Quijano and Yvonn Quijano And Modified by Gabriel Martinez 5 C H A P T E R Goods and Financial Markets: The IS-LM Model

Prepared by:Prepared by:

Fernando Quijano and Yvonn Fernando Quijano and Yvonn QuijanoQuijano

And Modified by Gabriel MartinezAnd Modified by Gabriel Martinez

55C H A P T E RC H A P T E R

Goods andGoods andFinancial Markets:Financial Markets:The IS-LM ModelThe IS-LM Model

© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Macroeconomics, 3/e Olivier BlanchardOlivier Blanchard

How are Output and the Interest How are Output and the Interest Rate Jointly Determined in the Short Rate Jointly Determined in the Short

Run? Run? Output and the interest rate are determined by Output and the interest rate are determined by

simultaneous equilibrium in the goods and money simultaneous equilibrium in the goods and money markets.markets.– In the short run, we assume that production responds to In the short run, we assume that production responds to

demand without changes in price (i.e., price is fixed), so demand without changes in price (i.e., price is fixed), so output is determined by demand. output is determined by demand.

The determination of output is the fundamental The determination of output is the fundamental issue in macroeconomics.issue in macroeconomics.– The interest rate affects output (through investment) and The interest rate affects output (through investment) and

output affects the interest rate (through money output affects the interest rate (through money demand), so it is necessary to consider the demand), so it is necessary to consider the simultaneous determination of output and the interest simultaneous determination of output and the interest rate.rate.


The Goods MarketThe Goods Marketand the and the ISIS Relation Relation

Equilibrium in the goods market exists Equilibrium in the goods market exists when production, when production, YY, is equal to the , is equal to the demand for goods, demand for goods, ZZ..

In the simple model developed in chapter In the simple model developed in chapter 3, the interest rate did not affect the 3, the interest rate did not affect the demand for goods. The equilibrium demand for goods. The equilibrium condition was given by:condition was given by:

5-1

Y C Y T I G ( )


Investment, Sales,Investment, Sales,and the Interest Rateand the Interest Rate

In this chapter, we capture the effects In this chapter, we capture the effects of two factors affecting investment:of two factors affecting investment:– The level of sales (+)The level of sales (+)

– The interest rate (-)The interest rate (-)),(

iYII


The Determination of OutputThe Determination of Output

I I Y i ( , )

Y C Y T I Y i G ( ) ( , )

Taking into account the investment relation Taking into account the investment relation above, the equilibrium condition in the above, the equilibrium condition in the goods market becomes:goods market becomes:

– Notice we don’t assume that the relation Notice we don’t assume that the relation between C and Y, or between I and Y, between C and Y, or between I and Y, hashas to be to be linear.linear.


The Determination of OutputThe Determination of Output

Note: The ZZ line is flatter than the 45° line because the econometric evidence tells us that increases in consumption and investment do not exceed the corresponding increase in output.

The demand for goods is an increasing function of output. Equilibrium requires that the demand for goods be equal to output.

Equilibrium in the Goods Equilibrium in the Goods MarketMarket


Consumption on GDP

y = 0.6942x - 106.02

R2 = 0.9965

0.0

2000.0

4000.0

6000.0

8000.0

10000.0

0.0 2000.0 4000.0 6000.0 8000.0 10000.0 12000.0

69.0

Y

C


Investment on GDP

y = 0.1619x - 128.41

R2 = 0.9748

-500.0

0.0

500.0

1000.0

1500.0

2000.0

0.0 2000.0 4000.0 6000.0 8000.0 10000.0 12000.0

16.0Y

I


Change of Consumption on Change of GDP

y = 0.2857x + 0.0234

R2 = 0.2296

-0.1

-0.05

0

0.05

0.1

0.15

-0.15 -0.1 -0.05 0 0.05 0.1 0.15 0.2 0.25


Change of Investment on Change of GDP

y = 0.4868x + 0.0332

R2 = 0.0217

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1

-0.15 -0.1 -0.05 0 0.05 0.1 0.15 0.2 0.25


Deriving the Deriving the ISIS Curve Curve

An increase in the interest rate decreases the demand for goods at any level of output.

By the multiplier effect, output falls.

The Effects of an The Effects of an Increase inIncrease inthe Interest Rate on the Interest Rate on OutputOutput


Deriving the Deriving the ISIS Curve Curve

In Words:In Words: ii rises rises InvestmentInvestment falls falls The ZZ curve shifts down The ZZ curve shifts down Equilibrium output falls.Equilibrium output falls. In the goods marketIn the goods market, there is an inverse , there is an inverse

relation between relation between ii and and YY..


Deriving the Deriving the ISIS CurveCurve

Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output. The IS curve is downward sloping.

The Derivation of the IS The Derivation of the IS CurveCurve


Shifts of the Shifts of the ISIS Curve Curve

An increase in taxes shifts the IS curve to the left.

Shifts of the IS Shifts of the IS CurveCurve

Y C Y T I Y i G ( ) ( , )


Shifts of the Shifts of the ISIS Curve Curve

The IS curve shifts to the The IS curve shifts to the rightright if: if:– Taxes fall,Taxes fall,– Government spending rises,Government spending rises,– Autonomous Investment rises,Autonomous Investment rises,

(that is, (that is, II rises for reasons besides rises for reasons besides ii or or YY))

– Autonomous Consumption rises.Autonomous Consumption rises.

It does not shift when It does not shift when ii or or YY change. change.


Every point on the IS curveEvery point on the IS curve is an is an equilibrium for the goods market.equilibrium for the goods market.

Income, Y

Inte

rest

, i

Y

Z

ZZ,

Medium Interest Rate

Y

ZZZ,Low Interest Rate

Y

ZZZ,High interest rate


Every point on the IS curveEvery point on the IS curve is an is an equilibrium for the goods market.equilibrium for the goods market.

Income, Y

Inte

rest

, i

Y

Z

ZZ,

Medium Interest Rate

IS’ (high consumer confidence)

IS (low consumer confidence)


Financial MarketsFinancial Marketsand the and the LMLM Relation Relation

The interest rate is determined by the The interest rate is determined by the equality of the supply of and the demand for equality of the supply of and the demand for money:money:

5-2

MM = nominal money stock = nominal money stockPYLPYL((ii) = demand for money) = demand for moneyPYPY = = $Y $Y = nominal income= nominal incomeii = nominal interest rate = nominal interest rate

)(iPYLM


Real Money, Real Income,Real Money, Real Income,and the Interest Rateand the Interest Rate

The The LMLM relation relation: In equilibrium, the real money : In equilibrium, the real money supply is equal to the real money demand, which supply is equal to the real money demand, which depends on real income, Y, and the interest rate, i:depends on real income, Y, and the interest rate, i:

M

PY L i ( )


Deriving the Deriving the LMLM Curve Curve

Suppose Real Income increases:Suppose Real Income increases: YY rises rises People demand more money for People demand more money for

transactions transactions MMdd shifts out. shifts out. If MIf Mss is vertical, is vertical, ii rises … rises … … … until the quantity of money demanded until the quantity of money demanded

equals the quantity of money supplied, equals the quantity of money supplied, which is fixed.which is fixed.



An increase in income leads, at a given interest rate, to an increase in the demand for money. Given the money supply, this leads to an increase in the equilibrium interest rate.

The Effects of an The Effects of an Increase in Income on Increase in Income on the Interest Ratethe Interest Rate



Equilibrium in financial markets implies that an increase in income leads to an increase in the interest rate. The LM curve is upward-sloping.


Shifts of the Shifts of the LMLM Curve Curve

If the Central Bank increases the money supply, the LM curve shifts down.

Shifts of the LM Shifts of the LM CurveCurve

The LM curve shifts in response to any factor that affects the money market, except i or Y.


Every point on the LM curveEvery point on the LM curve is an is an equilibrium for the money market.equilibrium for the money market.

Income, Y

Inte

rest

, i

M/P

inte

rest

, i

Md, High income

Ms

M/P

inte

rest

, i

Md, Medium income

Ms

M/P

inte

rest

, i

Md, Low income

Ms


Putting the Putting the ISIS and the and theLMLM Relations Together Relations Together

Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output.

Equilibrium in financial markets implies that an increase in output leads to an increase in the interest rate.

When the IS curve intersects the LM curve, both goods and financial markets are in equilibrium.

5-3

IS re la tio n : Y C Y T I Y i G( ) ( , )

L M rela tio n: M

PY L i( )

The IS-LM ModelThe IS-LM Model


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

Fiscal contractionFiscal contraction refers to fiscal policy refers to fiscal policy that reduces the budget deficit.that reduces the budget deficit.

An increase in the deficit is called a An increase in the deficit is called a fiscal fiscal expansionexpansion..

Consider an increase in taxes.Consider an increase in taxes. Taxes affect the Taxes affect the ISIS curve, not the curve, not the LMLM curve. curve.



Suppose the government raises taxes.Suppose the government raises taxes. Higher Taxes affect the Higher Taxes affect the ISIS curve: curve:

– They reduce disposable income, so that there is They reduce disposable income, so that there is less consumption at every level of Y.less consumption at every level of Y.

Y

ZZZ

ZZ Y falls at every level of interest.

Y

i

IS

IS’



Suppose the government raises taxes.Suppose the government raises taxes. Higher Taxes do not affect the Higher Taxes do not affect the LMLM curve: curve:

– Neither disposable income nor taxes appear in Neither disposable income nor taxes appear in the money market.the money market.

i stays the same at every level of Y.

M/P

i

Md

Ms

Y

iLM



An increase in taxes shifts the IS curve to the left, and leads to a decrease in the equilibrium level of output and the equilibrium interest rate.

The Effects of an The Effects of an Increase in TaxesIncrease in Taxes



Higher taxes shift the IS curve to the left and leave Higher taxes shift the IS curve to the left and leave the LM curve unchanged.the LM curve unchanged.

At the old level of interest rates, income has fallen.At the old level of interest rates, income has fallen. This causes the This causes the MMdd curve to move to the left in the curve to move to the left in the

money market.money market. This causes a This causes a movement along movement along the LM curve.the LM curve.

– The money market changed due to a change in The money market changed due to a change in YY, so the , so the MMdd curve shifts but the LM curve curve shifts but the LM curve does notdoes not shift. shift.

Equilibrium is restored at lower Equilibrium is restored at lower ii and lower and lower YY..


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

Monetary contractionMonetary contraction, or , or monetary monetary tightening,tightening, refers to a decrease in the money refers to a decrease in the money supply.supply.

An increase in the money supply is called An increase in the money supply is called monetary expansionmonetary expansion..

Monetary policy does not affect the Monetary policy does not affect the ISIS curve, curve, only the only the LMLM curve. For example, an increase curve. For example, an increase in the money supply shifts the in the money supply shifts the LMLM curve curve down. down.



Suppose the Central Bank expands the Suppose the Central Bank expands the Money Supply.Money Supply.

Higher MHigher Mss does not affect the does not affect the ISIS curve: curve:– The Money Supply does not appear in the The Money Supply does not appear in the

goods market.goods market.

Y

ZZZ

Y stays the same at any i.

Y

i

IS



Suppose the Central Bank expands the Money Suppose the Central Bank expands the Money Supply.Supply.

Higher MHigher Mss shifts the shifts the LMLM curve to the right: curve to the right:– A greater money supply lowers the interest rate at every A greater money supply lowers the interest rate at every

level of income.level of income.

i falls at every level of Y.

M/P

i

Md

Ms

Y

iLM

Ms’ LM



Monetary expansion leads to higher output and a lower interest rate.

The Effects of a The Effects of a Monetary ExpansionMonetary Expansion



Higher Money Supply shifts the LM curve to the Higher Money Supply shifts the LM curve to the right and leave the IS curve unchanged.right and leave the IS curve unchanged.

At the old level of income, interest rates have fallen.At the old level of income, interest rates have fallen. This causes Investment to increase, shifting the ZZ This causes Investment to increase, shifting the ZZ

curve up in the goods market.curve up in the goods market. The increase in income causes a The increase in income causes a movement along movement along

the IS curve.the IS curve.– The goods market changed due to a change in The goods market changed due to a change in ii, so the , so the

ZZ curve shifts but the IS curve ZZ curve shifts but the IS curve does notdoes not shift. shift.

Equilibrium is restored at lower Equilibrium is restored at lower ii and higher and higher YY..


Using a Policy MixUsing a Policy Mix

The combination of monetary and fiscal polices is known The combination of monetary and fiscal polices is known as the as the monetary-fiscal policy mix,monetary-fiscal policy mix, or simply, the or simply, the policy policy mix.mix.

5-4


The Clinton-Greenspan Policy The Clinton-Greenspan Policy MixMix

Table 5-2 Selected Macro Variables for the United States, 1991-1998

19911991 19921992 19931993 19941994 19951995 19961996 19971997 19981998

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

3.3 4.5 3.8 2.7 2.4 1.4 0.3 0.8

GDP growth (%) 0.9 2.7 2.3 3.4 2.0 2.7 3.9 3.7

Interest rate (%) 7.3 5.5 3.7 3.3 5.0 5.6 5.2 4.8

Over the 90’s, fiscal policy was contractionary and monetary policy was expansionary. This led to low interest rates and high output growth.


The Clinton-Greenspan Policy The Clinton-Greenspan Policy MixMix

The appropriate combination of deficit reduction and monetary expansion can achieve a reduction in the deficit without adverse effects on output.

Deficit Reduction and Deficit Reduction and Monetary ExpansionMonetary Expansion


German Unification and the German Unification and the German Monetary-Fiscal Tug of German Monetary-Fiscal Tug of

WarWarThe Monetary-Fiscal The Monetary-Fiscal Policy Mix of Post-Policy Mix of Post-Unification GermanyUnification Germany


How does the IS-LMHow does the IS-LMModel Fit the Facts?Model Fit the Facts?

The two dotted lines and the tinted space between them gives us a The two dotted lines and the tinted space between them gives us a confidence confidence band,band, a band within which the true value of the effect lies with 60% probability. a band within which the true value of the effect lies with 60% probability.

In the short run, an increase in the federal funds rate leads toa decrease in output andan decrease in production,But so that, for a while, sales are below production and inventories accumulate.

The Empirical Effects of The Empirical Effects of an Increasean Increasein the Federal Funds in the Federal Funds RateRate

5-5



The two dotted lines and the tinted space between them gives us a The two dotted lines and the tinted space between them gives us a confidence confidence band,band, a band within which the true value of the effect lies with 60% probability. a band within which the true value of the effect lies with 60% probability.

In the short run, an increase in the federal funds rate leads toan increase in unemployment,but little effect on the price level.

The Empirical Effects of The Empirical Effects of an Increasean Increasein the Federal Funds in the Federal Funds RateRate



In general, the IS-LM model seems to be In general, the IS-LM model seems to be a pretty good description of the short a pretty good description of the short run.run.– Econometric evidence tells us (within Econometric evidence tells us (within

certain bounds of error) that certain bounds of error) that contractionary contractionary monetary policymonetary policy

– Lowers employmentLowers employment

– … … without changing priceswithout changing prices

– (which is what we assumed in this chapter).(which is what we assumed in this chapter).


What did I learn in this chapter?What did I learn in this chapter?

Tools and ConceptsTools and Concepts– The IS-LM framework.The IS-LM framework.

The simultaneous determination of income The simultaneous determination of income andand interest rates; how different shocks affect interest rates; how different shocks affect these two.these two.

– The option of choosing alternative policy The option of choosing alternative policy mixes to achieve macroeconomic goals. mixes to achieve macroeconomic goals.

– The use of “+” and “-” below the argument The use of “+” and “-” below the argument of a function to indicate the effect of an of a function to indicate the effect of an increase in the value of the argument on increase in the value of the argument on the value of the function. the value of the function.


What did I learn in this chapter?What did I learn in this chapter?

RememberRemember– We still assume prices are fixed,We still assume prices are fixed,– But we relax the assumptions that investment is But we relax the assumptions that investment is

independent of the interest rate (assumed in independent of the interest rate (assumed in Chapter 3) and that nominal income is fixed Chapter 3) and that nominal income is fixed (assumed in Chapter 4).(assumed in Chapter 4).

– Investment is also allowed to depend on output.Investment is also allowed to depend on output.– The point of this chapter is to show how goods The point of this chapter is to show how goods

and financial markets are related and thus how and financial markets are related and thus how output and the interest rate are simultaneously output and the interest rate are simultaneously determined.determined.

– We continue to assume the economy is closed.We continue to assume the economy is closed.

Documents

Prepared by: Fernando Quijano and Yvonn Quijano And Modified by Gabriel Martinez 5 C H A P T E R Goods and Financial Markets: The IS-LM Model