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Chapter 5 Goods and Financial Markets: the IS-LM Model

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Chapter 5

Goods and Financial Markets: the IS-LM Model

Power Point Presentation

Brian VanBlarcom

Acadia University

THE IS-LM FRAMEWORK

IS-LM

- The IS/LM model is a macroeconomic tool that demonstrates the relationship between interest rates and real output in the goods and services market and the money market.
- The intersection of the IS and LM curves is the "General Equilibrium" where there is simultaneous equilibrium in both markets
- IS/LM stands for Investment Saving / Liquidity preference Money supply.

THE IS-LM FRAMEWORK

IS-LM - HISTORY

- The IS/LM model was born at the Econometric Conference held in Oxford during September, 1936.
- Roy Harrod, John R. Hicks, and James Meade all presented papers describing mathematical models attempting to summarize John Maynard Keynes' General Theory of Employment, Interest, and Money.

THE IS-LM FRAMEWORK

IS-LM - HISTORY

- Although disputed in some circles and accepted to be imperfect, the model is widely used and seen as useful in gaining an understanding of macroeconomic theory.

THE IS-LM FRAMEWORK

IS-LM - FORMULATION

- The model is presented as a graph of two intersecting lines in the first quadrant.
- The horizontal axis represents national income or real gross domestic product and is labelled Y. The vertical axis represents the real interest rate, i. Since this is a non-dynamic model, there is a fixed relationship between the nominal interest rate and the real interest rate (the former equals the latter plus the expected inflation rate which is exogenous in the short run); therefore variables such as money demand which actually depend on the nominal interest rate can equivalently be expressed as depending on the real interest rate.

THE IS-LM FRAMEWORK

IS-LM - FORMULATION

- The point where these schedules intersect represents a short-run equilibrium in the real and monetary sectors (though not necessarily in other sectors, such as laboUr markets): both the product market and the money market are in equilibrium. This equilibrium yields a unique combination of the interest rate and real GDP.
- Lets now begin with our explanation of the IS-LM framework…

The Goods Markets and the IS Relation

The goods market and the IS relation

- Equilibrium in the goods market:Production (Y) = Demand (Z)
- Demand (Z)= C+I+GC=C(Y-T)T, I, & G are given

A Review

The goods market and the IS relation

- Equilibrium: Y=C(Y-T)+I+G
- Changes in C, I, & G impact the equilibrium Y

A Review (Continued)

Investment, sales, and the interest rate

Investment depends on:

The level of sales

The interest rate

Therefore:

Supply of

Goods

Demand for

Goods (Z)

The IS curve

Equilibrium:

The IS curve

ZZ: Demand, a function of

Y for given i

equilibrium at a, Y

ZZ (i)

a

ZZ´ (i´ > i)

Demand, Z

b

ZZ´: Demand with higher i

equilibrium at b, Y´

Y

Y´

Output, Y

A

A´

i´

A´

A

i

Y´

Y

The IS curve

ZZ (i)

Demand, Z

ZZ´ (i´ > i)

Interest Rate, i

IS

Y

Y´

Output, Y

Output, Y

Observation:

In the goods market, the higher the interest rate, the lower the equilibrium output.

i

IS (T)

IS´ (T´ > T)

Y

Y´

The IS curve

Shifts in the IS Curve:

An increase in taxes shifts the IS curve to the left

Interest Rate, i

Output, Y

i

IS´ (G´ > G)

IS (G)

Y´

Y

The IS curve

Shifts in the IS Curve:

An increase in G shifts the IS curve to the right

Interest Rate, i

Output, Y

Shifts in the IS curve

What do you think:

How would a decrease in consumer confidence shift the IS curve?

Money market equilibrium revisited

M = nominal money supply (controlled by the Central Bank)

$YL(i)= Demand for money (function of nominal income and the interest rate)

Equilibrium Interest Rate:

M=$YL(i)

Real Income

Real Money Supply =Real Money Demand: Y(L)i

LM relation:

Real money, real income, and the interest rate

Ms

A´

i´

A

i

Md´ (for Y´ > Y)

Md (for Y)

M/P

The LM curve

Increase in Y => increases Md which increases i

Interest Rate, i

(Real) Money, M/P

Ms

LM (M/P)

i´

A´

A´

i´

i

A

A

i

Md´ (for Y´ > Y)

Md (for Y)

M/P

Y

Y´

The LM curve

Interest Rate, i

Interest Rate, i

Income, Y

(Real) Money, M/P

The LM curve

Question:

Why does higher economic activity putpressure on interest rates?

Ms´

b´

b´

a´

a´

Shifts in the LM Curve:

Showing changes in M & P

The LM curve

Interest Rate, i

LM (M/P)

Ms

LM´

(M´/P > M/P)

i´

b

b

i´

Interest Rate, i

i´2

i´2

a

i

a

i

Md´ (for Y´ > Y)

i2

i2

Md (for Y)

M/P

M´/P

Y

Y´

Income, Y

(Real) Money, M/P

Equilibrium Requires:

i & Y is the only interest rate, output combination that yields a simultaneous equilibrium in the goods and financial markets

i

The IS-LM Equilibrium Graphically

LM

Interest Rate, i

IS

Y

Output, Y

A Scenario:

The government decides to reduce the budget deficit by increasing taxes, while holding government spending constant.

Question:

What impact will this fiscal contraction policy have on output and interest rates?

The IS-LM Equilibrium Graphically

- IS & LM: Before the tax increase
- Equilibrium A: i & Y

LM

- IS´: After the tax increase

- Would the tax increase change
- LM?

- Disequilibrium at i (F, A) after
- tax increase

Interest Rate, i

A

F

- i´, Y´ New equilibrium A´

i

A´

- The fiscal contraction lowered
- interest and output

i´

IS (T)

IS´ (T´ > T)

Y´

Y

Output, Y

A Scenario:

The Bank of Canada engages in monetary expansion, i.e., it increases the money supply through open market operations

Question:

What impact will the monetary expansion have on output and interest?

The IS-LM Equilibrium Graphically

LM (M/P)

LM´ (M´/P > M/P)

- IS & LM: Before increasing M
- Equilibrium A: i & Y

Interest Rate, i

B

- LM´: After increasing M

A

i

- Disequilibrium at i (A, B)

A´

i´

- New equilibrium A´: i´ & Y´

- Monetary expansion
- lowered i & increased Y

IS

Y

Y´

Output, Y

The effects of fiscal and monetary policy

The policy dilemma of 1993:

Record high federal budget deficit (5.4% of GDP)

High unemployment and slow growth

Deficit reduction reduces output

Expansionary fiscal policy increases the deficit

Deficit reduction and expansionary monetary policy

Recall:

Solution: Policy Mix

The Martin-Thiessen Policy Mix

The Martin-Thiessen Policy Mix

Deficit Reduction and Monetary expansion

Insert “In Depth Martin-Thiessen Policy Mix Box from page 91 including text and figure 1

The Martin-Thiessen Policy Mix

Observations:

- The combined effect of policies by the government to reduce the deficit and the central bank to lower interest rates allowed the economy to grow significantly from 1994-1999.
- This expansion increased tax revenues and helped turn a large deficit into a surplus.

- A review of Figure 4 explains the events around the 2001 recession:
- The large shift from IS to IS” represents the decline in investment spending that triggered the recession.
- The right shift from LM to LM’ represents the Federal Reserve decision to cut interest rates.
- The smaller shift from IS” to IS’ represents the increase in government spending and tax cuts.

- A review of Figure 4 explains the events around the 2001 recession:
- The economy would have been at A” without changes in monetary & fiscal policy.
- The decline in output was reduced from Y to Y” (without policy changes) to Y to Y’ (with policy changes).
- The policy changes made the recession less severe.

Questions

- Weren’t the events of September 11, 2001, the cause of the recession?
- Why is it not possible to avoid all recessions via monetary and fiscal policy?
- Was the monetary-fiscal mix used to fight the recession a textbook example of how policy should be conducted?
- Can the recession of 2008, initiated by the very sharp reduction in housing construction, be limited via lower interest rates and tax cuts?

LM´

B

iB

Output

decreases

slowly

B

Interest rates

adjust

instantaneously

IS´

Yb

Dynamics Graphically

Goods Market

Financial Markets

Adjusting to a

monetary contraction

LM

Adjusting to a

tax increase

Interest Rate, i

Interest Rate, i

A´

iA

iA

IS

A

Ya

Ya

Output, Y

Output, Y

The Dynamics of Monetary Contraction with IS-LM

LM´

LM

- A: Initial equilibrium (i & Y)

A´´

i´´

Interest Rate, i

- LM´: After reducing money
- supply

A´

i´

- i rises to i´´

A

- Higher i reduces demand
- and output slowly A´´ to A´

i

- New equilibrium at A´:
- ( i´, Y´)

IS

Y´

Y

Output, Y

A Summary

- Monetary policy changes interest rates rapidly and output slowly
- The Central Bank must consider the output lag when implementing monetary policy

Does the IS-LM Model Actually Capture What Happens in the Economy?

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?

The Empirical Effects of an Increase in the Interest Rates on the Canadian Economy

The Empirical Effects of an Increase in the Interest Rates on the Canadian Economy

- The IS-LM model explains movements in economic activity well in the short-run.
- The IS-LM model is consistent with economic observations once dynamics are introduced.
- An increase in the interest rate due to monetary contraction leads to a steady decline in output.
- An increase in investment or consumption leads to an increase in output.

- The IS-LM model illustrates the implications in both the goods and financial markets.
- The IS relation shows the equilibrium combinations of the interest rate and level of output in the goods market.
- An increase in interest rates leads to a decline in output.

- The LM relation shows the equilibrium combinations of the interest rate and level of output in the financial markets.
- Given the real money supply, an increase in output leads to an increase in the interest rate.
- A fiscal expansion shift IS to the right, leading to increased output and interest rate

- A monetary expansion shifts the LM curve down, leading to an increase in output and a decrease in interest rates.
- The combination of monetary and fiscal policies is know as the policy mix.
- Sometimes monetary policy and fiscal policy are used for a common goal.

End of Chapter

Goods and Financial Markets: the IS-LM Model