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Goods & Financial Markets: The IS-LM Model. The IS-LM Model. The determination of output and interest rates in the short-run. Goods & Financial Markets: The IS-LM Model. The goods market and the IS relation. Equilibrium in the goods market: Production ( Y ) = Demand ( Z )

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Goods & Financial Markets: The IS-LM Model

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Goods & Financial Markets: The IS-LM Model

The IS-LM Model

The determination of output and

interest rates in the short-run


Goods & Financial Markets: The IS-LM Model

The goods market and the IS relation

  • 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 letInvestment depend on the level of sales (Y) and the interest rate (i):


Supply of

Goods

Demand for

Goods (Z)

Goods & Financial Markets: The IS-LM Model

The IS curve

Equilibrium:

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


i

IS (T)

IS´ (T´ > T)

Y

Goods & Financial Markets: The IS-LM Model

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

Goods & Financial Markets: The IS-LM Model

The IS curve

Shifts in the IS Curve:

An increase in G shifts the IS curve to the right

Interest Rate, i

Output, Y


Goods & Financial Markets: The IS Curve

Shifts in the IS curve

What do you think:

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


Financial Markets and the LM Relation

Money market equilibrium:

Demand for liquidity (L) = Supply of Money (M)

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:

Financial Markets and the LM Relation

Real money, real income, and the interest rate


Ms

A

i

Md´ (for Y´ > Y)

Md (for Y)

M/P

Financial Markets and the LM Relation

An increase in demand for real balances:

Increase in Y => increases Md which increases i

Interest Rate, i

(Real) Money, M/P


Ms

LM (M/P)

i

A

A

i

Md´ (for Y´ > Y)

Md (for Y)

M/P

Y

Financial Markets and the LM Relation

The LM curve

Interest Rate, i

Interest Rate, i

Income, Y

(Real) Money, M/P


Ms´

Financial Markets and the LM Relation

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)

b

b

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

Income, Y

(Real) Money, M/P


The IS-LM Model Exercises

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 Model Exercises

The IS-LM Equilibrium Graphically

LM

Interest Rate, i

IS

Y

Output, Y


A Scenario:

The President and Congress agree on a policy to reduce the budget deficit by increasing taxes, while holding gov’t spending constant.

Question:

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

What shifts? IS, LM or both?

ANSWER: IS

Fiscal Policy, Activity, and the Interest Rate


Fiscal Policy, Activity, and the Interest Rate

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

  • The fiscal contraction lowered

  • interest and output

IS (T)

IS´ (T´ > T)

Y

Output, Y


Fiscal Policy, Activity, and the Interest Rate

Here’s one for the devil’s advocate…

Is deficit reduction good or bad for investment?

Interest rate falls  good for investment

But

Output falls  bad for investment


A Scenario:

The Fed 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?

What shifts? IS, LM, or both?

ANSWER: LM

Monetary Policy, Activity, and the Interest Rate

Monetary Policy, Activity, and the Interest Rate


Monetary Policy, Activity, and the Interest Rate

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)

  • New equilibrium A´: i´ & Y´

  • Monetary expansion

  • lowered i & increased Y

IS

Y

Output, Y


Fiscal Policy and Monetary Policy: Activity and the Interest Rate

The effects of fiscal and monetary policy


The policy dilemma of 1992:

Record high federal budget deficit (4.5% of GNP)

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

Using a Policy Mix

The Clinton-Greenspan Policy Mix


Using a Policy Mix

The Clinton-Greenspan Policy Mix

LM

LM´

  • IS & LM: Before policy changes

  • Equilibrium A: i & Y

Interest Rate, i

  • IS´: After deficit reduced

A

  • B equilibrium without monetary

  • expansion

i

B

  • LM´ after monetary expansion

  • New equilibrium i´, Y´

IS

IS´

Y

Output, Y


Using a Policy Mix

The Clinton-Greenspan Policy Mix

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%)


19911992199319941995199619971998

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

-0.92.72.33.42.02.73.93.7

7.35.53.73.35.05.65.24.8

Using a Policy Mix

The Clinton-Greenspan Policy Mix

The U.S. Economy 1991-1998


Adding Dynamics

Observations:

  • Changes in output adjust slowly to changes in the goods market (IS)

  • Interest rates adjust instantaneously to changes in the financial markets (LM)


LM´

B

iB

Output

decreases

slowly

B

Interest rates

adjust

instantaneously

IS´

Yb

Adding Dynamics

Dynamics Graphically

Adjusting to a

monetary contraction

Adjusting to a

tax increase

LM

Interest Rate, i

Interest Rate, i

iA

iA

IS

A

Ya

Ya

Output, Y

Output, Y


Adding Dynamics

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

  • i rises to i´´

A

  • Higher i reduces demand and

  • output slowly A´´ to A´

i

  • Equilibrium restored at A´: i´, Y´

IS

Y

Output, Y


Adding Dynamics

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?

The Empirical Effects of an Increase in the FederalFunds Rate


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

The Empirical Effects of an Increase in the FederalFunds Rate


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

The Empirical Effects of an Increase in the FederalFunds Rate


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

The Empirical Effects of an Increase in the FederalFunds Rate


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

The Empirical Effects of an Increase in the FederalFunds Rate


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

Summary

The IS-LM model is consistent with economic observations

The IS-LM model explains movements in economic activity over the short-run


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