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Goods & Financial Markets: The IS-LM Model

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The IS-LM Model

The determination of output and

interest rates in the short-run

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)

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

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:

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:

Real money, real income, and the interest rate

Ms

A´

i´

A

i

Md´ (for Y´ > Y)

Md (for Y)

M/P

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´

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

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 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

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

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

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 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

The Clinton-Greenspan 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

A´

- New equilibrium i´, Y´

i´

IS

IS´

Y

Y´

Output, Y

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

The Clinton-Greenspan Policy Mix

The U.S. Economy 1991-1998

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

Dynamics Graphically

Adjusting to a

monetary contraction

Adjusting to a

tax increase

LM

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

- Equilibrium restored 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

The Empirical Effects of an Increase in the FederalFunds Rate

The Empirical Effects of an Increase in the FederalFunds Rate

The Empirical Effects of an Increase in the FederalFunds Rate

The Empirical Effects of an Increase in the FederalFunds Rate

The Empirical Effects of an Increase in the FederalFunds Rate

Summary

The IS-LM model is consistent with economic observations

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