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IS-LM Slide #1Econ 302 Macroeconomic Analysis
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
IS-LM Slide #2Econ 302 Macroeconomic Analysis
Equilibrium in the goods market:Production (Y) = Demand (Z)
Demand (Z)= C+I+GC=C(Y-T)T, I, & G are given
The goods market and the IS relationThe goods market and the IS relation
Goods & Financial Markets: The Goods & Financial Markets: The IS-LMIS-LM Model Model
A ReviewA Review
IS-LM Slide #3Econ 302 Macroeconomic Analysis
Equilibrium: Y=C(Y-T)+I+G
Changes in C, I, & G impact the equilibrium Y
The goods market and the IS relationThe goods market and the IS relation
Goods & Financial Markets: The Goods & Financial Markets: The IS-LMIS-LM Model Model
A Review (Continued)A Review (Continued)
IS-LM Slide #4Econ 302 Macroeconomic Analysis
The goods market and the IS relationThe goods market and the IS relation
Goods & Financial Markets: The Goods & Financial Markets: The IS-LMIS-LM Model Model
Investment, sales, and the interest rateInvestment, sales, and the interest rate
Investment depends on:
The level of sales
The interest rate
Therefore:
),(
),(
iYII
),(
),(
iYII
IS-LM Slide #5Econ 302 Macroeconomic Analysis
The IS curveThe IS curve
Goods & Financial Markets: The Goods & Financial Markets: The IS-LMIS-LM Model Model
),( iYII ),( iYII
GITYCY )( GITYCY )(Equilibrium:
GiYITYCY ),()( GiYITYCY ),()(
Supply ofGoods
Demand forGoods (Z)
IS-LM Slide #6Econ 302 Macroeconomic Analysis
The IS curveThe IS curve
Goods & Financial Markets: The Goods & Financial Markets: The IS-LMIS-LM Model Model
Dem
and
, Z
Output, Y
45°
b
a
YY´
ZZ (i)
ZZ´ (i´ > i)
ZZ: Demand, a function ofY for given i
equilibrium at a, Y
ZZ´: Demand with higher i
equilibrium at b, Y´
IS-LM Slide #7Econ 302 Macroeconomic Analysis
The IS curveThe IS curve
Goods & Financial Markets: The Goods & Financial Markets: The IS-LMIS-LM Model ModelD
em
an
d,
Z
Output, Y
45°
YY´
ZZ (i)
ZZ´ (i´ > i)
Inte
res
t R
ate
, i
Output, Y
A
A
Y
i
A´A´
Y´
i´
IS
IS-LM Slide #8Econ 302 Macroeconomic Analysis
Observation:Observation:
Goods & Financial Markets: The Goods & Financial Markets: The IS-LMIS-LM Model Model
In the goods market, the higher the interest rate, the lower the equilibrium output.
In the goods market, the higher the interest rate, the lower the equilibrium output.
IS-LM Slide #9Econ 302 Macroeconomic Analysis
i
Y
IS (T)
The IS curveThe IS curve
Goods & Financial Markets: The Goods & Financial Markets: The IS-LMIS-LM Model 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
IS-LM Slide #10Econ 302 Macroeconomic Analysis
IS (G)
Y
i
The IS curveThe IS curve
Goods & Financial Markets: The Goods & Financial Markets: The IS-LMIS-LM Model 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
IS-LM Slide #11Econ 302 Macroeconomic Analysis
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?
IS-LM Slide #12Econ 302 Macroeconomic Analysis
Money market equilibrium revisitedMoney market equilibrium revisited
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)
IS-LM Slide #13Econ 302 Macroeconomic Analysis
Real money, real income, and the interest rateReal money, real income, and the interest rate
Financial Markets and the Financial Markets and the LMLM Relation Relation
Real IncomeP
YY
$)(
Real Money Supply =Real Money Demand: Y(L)i
P
M
LM relation: iLYP
M)(
IS-LM Slide #14Econ 302 Macroeconomic Analysis
Md (for Y)
M/P
Ai
Ms
The LM curveThe LM curve
Financial Markets and the Financial Markets and the LMLM Relation Relation
(Real) Money, M/P
Inte
rest
Rat
e, i
Increase in Y => increases Md which increases i
A´i´
Md´ (for Y´ > Y)
IS-LM Slide #15Econ 302 Macroeconomic Analysis
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 Financial Markets and the LMLM Relation RelationIn
tere
st
Ra
te,
i
(Real) Money, M/P
Interest Rate, i
Income, Y
IS-LM Slide #16Econ 302 Macroeconomic Analysis
The LM curveThe LM curve
Financial Markets and the Financial Markets and the LMLM Relation 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´
IS-LM Slide #17Econ 302 Macroeconomic Analysis
Equilibrium Requires:Equilibrium Requires:
The The IS-LMIS-LM Model Exercises Model Exercises
GiYITYCYIS ),()(:
)(: iYLP
MLM
LMISor
IS-LM Slide #18Econ 302 Macroeconomic Analysis
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
IS-LM Slide #19Econ 302 Macroeconomic Analysis
Fiscal Policy, Activity, and the Interest RateFiscal Policy, Activity, and the Interest Rate
Question:Question: What impact will the monetary expansion have on output and interest rate?
What impact will the monetary expansion have on output and interest rate?
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
IS-LM Slide #20Econ 302 Macroeconomic Analysis
The IS-LM Equilibrium GraphicallyThe IS-LM Equilibrium Graphically
Fiscal Policy, Activity, and the Interest RateFiscal 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
IS-LM Slide #21Econ 302 Macroeconomic Analysis
The effects of fiscal and monetary policyThe effects of fiscal and monetary policy
Fiscal Policy, Activity, and the Interest RateFiscal 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
IS-LM Slide #22Econ 302 Macroeconomic Analysis
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
IS-LM Slide #23Econ 302 Macroeconomic Analysis
Using a Policy MixUsing 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
IS-LM Slide #24Econ 302 Macroeconomic Analysis
Using a Policy MixUsing a Policy Mix
German Unification & the German Monetary Fiscal Tug-of-WarGerman Unification & the German Monetary Fiscal Tug-of-War
The Scenario:The Scenario:
• Prior to unification, West Germany was exhibiting strong growth, investment
• After unification, strong fiscal stimulus from increased governmental spending on infrastructure and slow investment growth.
IS-LM Slide #25Econ 302 Macroeconomic Analysis
Using a Policy MixUsing a Policy Mix
German Unification & the German Monetary Fiscal Tug-of-WarGerman Unification & the German Monetary Fiscal Tug-of-War
Output, Y
Inte
rest
Rat
e, i
Y´
i´
LM
Y
iA
IS´
A´
LM´
• A (i, Y) pre-unification equilibrium
• IS´: Post-unification IS
• LM´: Post-unification LM: Reduction in M to offset IS expansion
• A´(i´, Y´) post-unification equilibrium
IS
IS-LM Slide #26Econ 302 Macroeconomic Analysis
Using a Policy MixUsing a Policy Mix
German Unification & the German Monetary Fiscal Tug-of-WarGerman Unification & the German Monetary Fiscal Tug-of-War
The West German Economy, 1998-1991The West German Economy, 1998-1991
1988 1989 1990 1991
BDGP growth (%) 3.7 3.8 4.5 3.1Investment*growth (%) 5.9 8.5 10.5 6.7Budget surplus (% of GDP) -2.1 0.2 -1.8 -2.9 (minus sign: deficit)Interest rate (short term) 4.3 7.1 8.5 9.2
IS-LM Slide #27Econ 302 Macroeconomic Analysis
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)
IS-LM Slide #28Econ 302 Macroeconomic Analysis
LM´
Adding DynamicsAdding 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
IS-LM Slide #29Econ 302 Macroeconomic Analysis
Adding DynamicsAdding 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´´
IS-LM Slide #30Econ 302 Macroeconomic Analysis
Adding DynamicsAdding 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
IS-LM Slide #31Econ 302 Macroeconomic Analysis
Does the Does the IS-LMIS-LM Model Actually Capture What Model Actually Capture What Happens in the Economy?Happens in the Economy?
Does the IS-LM model pass two tests?Does the IS-LM model pass two tests?
Are the assumptions of IS-LM reasonable?
Are the implications of IS-LM consistent with real-world observations?
Are the assumptions of IS-LM reasonable?
Are the implications of IS-LM consistent with real-world observations?
IS-LM Slide #32Econ 302 Macroeconomic Analysis
Does the Does the IS-LMIS-LM Model Actually Capture What Model Actually Capture What Happens in the Economy?Happens in the Economy?
Are the assumptions of IS-LM reasonable?
Are the implications of IS-LM consistent with real-world observations?
Are the assumptions of IS-LM reasonable?
Are the implications of IS-LM consistent with real-world observations?
The Empirical Effects of an Increase in the FederalFunds RateThe Empirical Effects of an Increase in the FederalFunds Rate
IS-LM Slide #33Econ 302 Macroeconomic Analysis
Does the Does the IS-LMIS-LM Model Actually Capture What Model Actually Capture What Happens in the Economy?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