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Chapter 5 Goods and Financial Markets: the IS-LM ModelPowerPoint Presentation

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

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### End of Chapter

Goods and Financial Markets: the IS-LM Model

Power Point Presentation

Brian VanBlarcom

Acadia University

The Goods Markets and the IS Relation

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 Goods Markets and the IS Relation

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 Goods Markets and the IS Relation

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 Goods Markets and the IS Relation

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 Goods Markets and the IS Relation

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 Markets and the IS RelationThe goods market and the IS relation

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

A Review

The Goods Markets and the IS Relation

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)

The Goods Markets and the IS Relation

Investment, sales, and the interest rate

Investment depends on:

The level of sales

The interest rate

Therefore:

Goods

Demand for

Goods (Z)

The Goods Markets and the IS RelationThe IS curve

Equilibrium:

The Goods Markets and the IS Relation

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´

i´

A´

A

i

Y´

Y

The Goods Markets and the IS RelationThe IS curve

ZZ (i)

Demand, Z

ZZ´ (i´ > i)

Interest Rate, i

IS

Y

Y´

Output, Y

Output, Y

The Goods Markets and the IS Relation

Observation:

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

IS (T)

IS´ (T´ > T)

Y

Y´

The Goods Markets and the IS RelationThe IS curve

Shifts in the IS Curve:

An increase in taxes shifts the IS curve to the left

Interest Rate, i

Output, Y

IS´ (G´ > G)

IS (G)

Y´

Y

The Goods Markets and the IS RelationThe IS curve

Shifts in the IS Curve:

An increase in G shifts the IS curve to the right

Interest Rate, i

Output, Y

The Goods Markets and the IS Relation

Shifts in the IS curve

What do you think:

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

The Financial Market and the LM Relation

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

LM relation:

The Financial Market and the LM RelationReal money, real income, and the interest rate

Ms

A´

i´

A

i

Md´ (for Y´ > Y)

Md (for Y)

M/P

The Financial Market and the LM RelationThe 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 Financial Market and the LM RelationThe LM curve

Interest Rate, i

Interest Rate, i

Income, Y

(Real) Money, M/P

The Financial Market and the LM Relation

The LM curve

Question:

Why does higher economic activity putpressure on interest rates?

Ms´

b´

b´

a´

a´

The Financial Market and the LM RelationShifts 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

The IS – LM Model

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 ModelThe IS-LM Equilibrium Graphically

LM

Interest Rate, i

IS

Y

Output, Y

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?

Fiscal Policy, Activity and the Interest RateFiscal 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

A´

- The fiscal contraction lowered
- interest and output

i´

IS (T)

IS´ (T´ > T)

Y´

Y

Output, Y

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?

Monetary Policy, Activity, and the Interest RateMonetary 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 IS – LM Model

The effects of fiscal and monetary policy

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 IS – LM ModelThe Martin-Thiessen Policy Mix

The IS – LM Model

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 IS – LM Model

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.

The U.S. Economy and the IS-LM Model after 2000

The U.S. Economy and the IS-LM Model after 2000

The U.S. Economy and the IS-LM Model after 2000

- 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.

The U.S. Economy and the IS-LM Model after 2000

- 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.

The U.S. Economy and the IS-LM Model after 2000

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?

B

iB

Output

decreases

slowly

B

Interest rates

adjust

instantaneously

IS´

Yb

Adding DynamicsDynamics 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

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

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

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?

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?

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

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

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

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

Does the IS-LM Model Actually Capture What Happens in the 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.

Summary

- 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.

Summary

- 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

Summary

- 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.

Goods and Financial Markets: the IS-LM Model

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