Lecture ISLM

7/31/2019 Lecture ISLM

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Economic Environment of Business

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Partha Chatterjee, FMS, University of Delhi


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So far

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Goods market Market for money and bonds

Next:

We will combine those two

Study IS-LM model

Talk about Fiscal and Monetary Policy


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The Goods Market

and the ISRelation

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Equilibrium in the goods market exists whenproduction, Y, is equal to the demand for goods, Z.This condition is called the IS relation.

In the simple model developed earlier, the interestrate did not affect the demand for goods. Theequilibrium condition was given by:

Y C Y T I G ( )


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Investment, Sales,

and the Interest Rate

Here, we capture the effects of two factorsaffecting investment:

The level of sales (+)

The interest rate (-)

( , )

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I I Y i ( , )


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Determining Output

Taking into account the investment relation

above, the equilibrium condition in the goodsmarket becomes:

( , )

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I I Y i ( , )

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


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Determining Output

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For a given value of the interest rate i, demandis an increasing function of output, for tworeasons:

An increase in output leads to an increase inincome and also to an increase in disposableincome.

An increase in output also leads to an

increase in investment.


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The Determination of Output

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The demand for goods is

an increasing function ofoutput. Equilibrium

requires that the demand

for goods be equal to

output.

Equilibrium in theGoods Market


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The Determination of Output

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Note two characteristics of ZZ:

Because its not assumed

that the consumption and

investment relations arelinear, ZZ is, in general, a

curve rather than a line.

ZZ is drawn flatter than a

45-degree line because its

assumed that an increasein output leads to a less

than one-for-one increase

in demand.


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Deriving the ISCurve

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An increase in theinterest rate decreases

the demand for goods at

any level of output.

The Effects of anIncrease inthe Interest Rate onOutput


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Equilibrium in the goodsmarket implies that anincrease in the interest

rate leads to a decreasein output. The IScurve isdownward sloping.

The Derivation of the ISCurve


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Using the last slide, we can find the relation betweenequilibrium output and the interest rate.

Panel (a) reproduces the figure in the last slide. Theinterest rate iimplies a level of output equal to Y.

Panel (b) plots equilibrium output Yon the horizontal

axis against the interest rate on the vertical axis.

This relation between the interest rate and output isrepresented by the downward sloping curve, or IScurve.


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Example: Shifts of the ISCurvedue to Tax

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An increase intaxes shifts the IS

curve to the left.

Shifts of the IS

Curve


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Shifts of the ISCurve

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Lets summarize:

Equilibrium in the goods market implies that an

increase in the interest rate leads to a decrease inoutput.

Changes in factors that decrease the demand forgoods, given the interest rate shift the IScurve to the

left.


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Financial Markets

and the LMRelation

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

M YL i $ ( )

M= nominal money stock$YL(i) = demand for money$Y= nominal incomei= nominal interest rate


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Real Money, Real Income,


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The LMrelation: In equilibrium, the real moneysupply is equal to the real money demand, whichdepends on real income, Y, and the interest rate, i:

M

PYL i ( )

$Y YP

Recall that Nominal GDP = Real GDP multipliedby the GDP deflator:

$Y

PY

Equivalently:


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Deriving the LMCurve

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An increase inincome leads, at agiven interest rate, toan increase in thedemand for money.Given the moneysupply, this leads toan increase in theequilibrium interestrate.

The Effects of anIncrease in Income onthe Interest Rate


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Equilibrium infinancial markets

implies that anincrease in incomeleads to an increase inthe interest rate. TheLMcurve is upward-sloping.

The Derivation of theLM Curve


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From the figure we learn:

Panel (b) plots the equilibrium interest rate ion thevertical axis against income on the horizontal axis

This relation between output and the interest rate isrepresented by the upward-sloping curve in Panel (b).This curve is called the LMcurve.


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Ex: Shifts of the LMCurvedue to

changes in real money

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An increase inmoney leads

the LMcurve toshift down.

Shifts of the LM

Curve


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Shifts of the LMCurve

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Lets summarize:

Equilibrium in financial markets implies that, for a

given real money supply, an increase in the level ofincome, which increases the demand for money, leadsto an increase in the interest rate.

An increase in the money supply shifts the LMcurve

down; a decrease in the money supply shifts the LMcurve up.


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Remember

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BothIS

andLM

curves represent relations betweenY& i. IS is for the goods market & LM is for the

financial market.

IScurve: from the goods market equilibrium

condition express Yas a function of i(or vice-versa) LMcurve: from the financial market equilibrium

condition express Yas a function of i(or vice-versa)


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Putting the ISand the

LMRelations Together

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Equilibrium in the goodsmarket implies that an increase

in the interest rate leads to adecrease in output. Equilibriumin financial markets implies thatan increase in output leads toan increase in the interest rate.When the IScurve intersects

the LMcurve, both goods andfinancial markets are inequilibrium.

IS relation: Y C Y T I Y i G( ) ( , )

LM relation:M

P YL i( )

The IS-LM Model


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Fiscal Policy, Activity,


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Fiscal contraction, or fiscalconsolidation, refers to fiscal policy thatreduces the budget deficit.

An increase in the deficit is called afiscal expansion.

Taxes affect the IScurve, not the LMcurve.


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Fiscal Policy, Activity,


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The Effects of anIncrease in Taxes

An increase in

taxes shifts the IS

curve to the left, and

leads to a decrease

in the equilibrium

level of output and

the equilibriuminterest rate.


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Tax cut and Economic Growth

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Can tax cut spur economic growth?


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Monetary Policy, Activity,


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

An increase in the money supply is called monetaryexpansion.

Monetary policy does not affect the IScurve, only theLMcurve. For example, an increase in the moneysupply shifts the LMcurve down.


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Monetary Policy, Activity,


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Monetary expansionleads to higher outputand a lower interestrate.

The Effects of aMonetary Expansion


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Using a Policy Mix

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

The Effects of Fiscal and Monetary Policy.

Shift of ISShift of

LMMovement of

OutputMovementin Interest

Rate

Increase in taxes left none down down

Decrease in taxes right none up up

Increase in

spending

right none up up

Decrease inspending

left none down down

Increase in money none down up down

Decrease in money none up down up

Lecture ISLM

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