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Slide #1
Goods & Financial Markets: The IS-LM Model
The IS-LM ModelThe IS-LM Model
The determination of output andinterest rates in the short-run
Slide #2
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
Goods & Financial Markets: The IS-LM Model
),(
),(
iYII
Slide #3
The IS curveThe IS curve
Goods & Financial Markets: The IS-LM Model
),( iYII
GITYCY )(
Equilibrium:
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.
Slide #4
i
Y
IS (T)
The IS curveThe IS curve
Goods & Financial Markets: The IS-LM Model
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
Slide #5
IS (G)
Y
i
The IS curveThe IS curve
Goods & Financial Markets: The IS-LM Model
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
Slide #6
Shifts in the IS curveShifts in the IS curve
Goods & Financial Markets: The IS Curve
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?
Slide #7
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 LM 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)
Slide #8
Real money, real income, and the interest rateReal money, real income, and the interest rate
Financial Markets and the LM Relation
Real IncomeP
YY
$)(
Real Money Supply =Real Money Demand: Y(L)i
P
M
LM relation: iLYP
M)(
Slide #9
Md (for Y)
M/P
Ai
Ms
An increase in demand for real balances:An increase in demand for real balances:
Financial Markets and the LM Relation
(Real) Money, M/P
Inte
rest
Rat
e, i
Increase in Y => increases Md which increases i
A´i´
Md´ (for Y´ > Y)
Slide #10
A´
Md´ (for Y´ > Y)
LM (M/P)
A A
Y
ii
Md (for Y)
M/P
Ms
i´A´
Y´
i´
The LM curveThe LM curve
Financial Markets and the LM RelationIn
tere
st
Ra
te,
i
(Real) Money, M/P
Interest Rate, i
Income, Y
Slide #11
The LM curveThe LM curve
Financial Markets and the LM Relation
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
Y´Y
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´
Slide #12
Equilibrium Requires:Equilibrium Requires:
The IS-LM Model Exercises
GiYITYCYIS ),()(:
)(: iYLP
MLM
LMISor
Slide #13
The IS-LM Equilibrium GraphicallyThe IS-LM Equilibrium Graphically
The IS-LM 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
Slide #14
Fiscal 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.
Slide #15
The IS-LM Equilibrium GraphicallyThe IS-LM Equilibrium Graphically
Fiscal Policy, Activity, and the Interest Rate
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´
Slide #16
Fiscal Policy, Activity, and the Interest Rate
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…
Slide #17
Monetary 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
Monetary Policy, Activity, and the Interest RateMonetary Policy, Activity, and the Interest Rate
Slide #18
The IS-LM Equilibrium GraphicallyThe IS-LM Equilibrium Graphically
Monetary Policy, Activity, and the Interest Rate
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
Slide #19
The effects of fiscal and monetary policyThe effects of fiscal and monetary policy
Fiscal Policy and Monetary Policy: Activity 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
Slide #20
Using 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
Slide #21
Using a Policy Mix
The Clinton-Greenspan Policy MixThe Clinton-Greenspan Policy Mix
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
Slide #22
Using a Policy Mix
The Clinton-Greenspan Policy MixThe Clinton-Greenspan Policy Mix
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%)
Slide #23
Using a Policy Mix
The Clinton-Greenspan Policy MixThe Clinton-Greenspan Policy Mix
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
Slide #24
Adding 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)
Slide #25
LM´
Adding Dynamics
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
Slide #26
Adding Dynamics
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´´
Slide #27
Adding Dynamics
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
Slide #28
Does the IS-LM Model Actually Capture What Happens in the Economy?
The Empirical Effects of an Increase in the FederalFunds RateThe Empirical Effects of an Increase in the FederalFunds Rate
Slide #29
Does the IS-LM Model Actually Capture What Happens in the Economy?
The Empirical Effects of an Increase in the FederalFunds RateThe Empirical Effects of an Increase in the FederalFunds Rate
Slide #30
Does the IS-LM Model Actually Capture What Happens in the Economy?
The Empirical Effects of an Increase in the FederalFunds RateThe Empirical Effects of an Increase in the FederalFunds Rate
Slide #31
Does the IS-LM Model Actually Capture What Happens in the Economy?
The Empirical Effects of an Increase in the FederalFunds RateThe Empirical Effects of an Increase in the FederalFunds Rate
Slide #32
Does the IS-LM Model Actually Capture What Happens in the Economy?
The Empirical Effects of an Increase in the FederalFunds RateThe Empirical Effects of an Increase in the FederalFunds Rate
Slide #33
Does the IS-LM Model Actually Capture What Happens in the Economy?
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