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9. ISLM model

9. ISLM model. In this lecture , you will learn…. an introduction to business cycle and aggregate demand the IS curve, and its relation to the Keynesian cross the loanable funds model the LM curve, and its relation to the theory of liquidity preference

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9. ISLM model

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  1. 9. ISLM model CHAPTER 9 Introduction to Economic Fluctuations

  2. In this lecture, you will learn… • an introduction to business cycle and aggregate demand • the IS curve, and its relation to • the Keynesian cross • the loanable funds model • the LM curve, and its relation to • the theory of liquidity preference • how the IS-LM model determines income and the interest rate in the short run when P is fixed CHAPTER 9 Introduction to Economic Fluctuations

  3. Short run • In the following lectures, we will study the short-run fluctuations of the economy (business cycles) • We focus on three models: • ISLM model (lecture 9) • Mudell-Fleming model (lecture 10) • Model AS-AD • AD (lectures 9 and 10) • AS (lecture 11) CHAPTER 9 Introduction to Economic Fluctuations

  4. Facts about the business cycle • GDP growth averages 3–3.5 percent per year over the long run with large fluctuations in the short run. • Consumption and investment fluctuate with GDP, but consumption tends to be less volatile and investment more volatile than GDP. • Unemployment rises during recessions and falls during expansions. • Okun’s Law: the negative relationship between GDP and unemployment. CHAPTER 9 Introduction to Economic Fluctuations

  5. Real GDP growth rate Consumption growth rate Average growth rate Growth rates of real GDP, consumption 10 Percent change from 4 quarters earlier 8 6 4 2 0 -2 -4 1970 1975 1980 1985 1990 1995 2000 2005 CHAPTER 9 Introduction to Economic Fluctuations

  6. Real GDP growth rate Investment growth rate Consumption growth rate Growth rates of real GDP, consumption, investment Percent change from 4 quarters earlier 40 30 20 10 0 -10 -20 -30 1970 1975 1980 1985 1990 1995 2000 2005 CHAPTER 9 Introduction to Economic Fluctuations

  7. 1970 1975 1980 1985 1990 1995 2000 2005 Unemployment Percent of labor force 12 10 8 6 4 2 0 CHAPTER 9 Introduction to Economic Fluctuations

  8. 1966 1951 1984 2003 1987 1975 2001 1982 1991 -3 -2 -1 0 1 2 3 4 Okun’s Law 10 Percentage change in real GDP 8 6 4 2 0 -2 -4 Change in unemployment rate CHAPTER 9 Introduction to Economic Fluctuations

  9. Time horizons in macroeconomics • Long run: Prices are flexible, respond to changes in supply or demand. • Short run:Many prices are “sticky” at some predetermined level. The economy behaves much differently when prices are sticky. CHAPTER 9 Introduction to Economic Fluctuations

  10. Recap of classical macro theory (Chaps. 3-8) • Output is determined by the supply side: • supplies of capital, labor • technology. • Changes in demand for goods & services (C, I, G ) only affect prices, not quantities. • Assumes complete price flexibility. • Applies to the long run. CHAPTER 9 Introduction to Economic Fluctuations

  11. When prices are sticky… …output and employment also depend on demand, which is affected by • fiscal policy (G and T ) • monetary policy (M ) • other factors, like exogenous changes in C or I. CHAPTER 9 Introduction to Economic Fluctuations

  12. The model of aggregate demand and supply • the paradigm most mainstream economists and policymakers use to think about economic fluctuations and policies to stabilize the economy • shows how the price level and aggregate output are determined • shows how the economy’s behavior is different in the short run and long run CHAPTER 9 Introduction to Economic Fluctuations

  13. IS-LM • This chapter develops the IS-LM model, the basis of the aggregate demand curve. • We focus on the short run and assume the price level is fixed. • This lecture focuses on the closed-economy case. • Next lecture presents the open-economy case. CHAPTER 9 Introduction to Economic Fluctuations

  14. The Keynesian Cross • A simple closed economy model in which income is determined by expenditure. (due to J.M. Keynes) • Notation: I = planned investment E = C + I + G = planned expenditure Y = real GDP = actual expenditure • Difference between actual & planned expenditure = unplanned inventory investment CHAPTER 9 Introduction to Economic Fluctuations

  15. Elements of the Keynesian Cross consumption function: govt policy variables: for now, plannedinvestment is exogenous: planned expenditure: equilibrium condition: actual expenditure = planned expenditure CHAPTER 9 Introduction to Economic Fluctuations

  16. E =C +I +G MPC 1 Graphing planned expenditure E planned expenditure income, output,Y CHAPTER 9 Introduction to Economic Fluctuations

  17. E =Y Graphing the equilibrium condition E planned expenditure 45º income, output,Y CHAPTER 9 Introduction to Economic Fluctuations

  18. Equilibrium income The equilibrium value of income E planned expenditure E =Y E =C +I +G income, output,Y CHAPTER 9 Introduction to Economic Fluctuations

  19. E At Y1, there is now an unplanned drop in inventory… E =C +I +G2 E =C +I +G1 G Y E1 = Y1 E2 = Y2 Y An increase in government purchases E =Y …so firms increase output, and income rises toward a new equilibrium. CHAPTER 9 Introduction to Economic Fluctuations

  20. Solve for Y : Solving for Y equilibrium condition in changes because I exogenous because C= MPCY Collect terms with Yon the left side of the equals sign: CHAPTER 9 Introduction to Economic Fluctuations

  21. The government purchases multiplier Definition: the increase in income resulting from a $1 increase in G. In this model, the govt purchases multiplier equals Example: If MPC = 0.8, then An increase in G causes income to increase 5 times as much! CHAPTER 9 Introduction to Economic Fluctuations

  22. Why the multiplier is greater than 1 • Initially, the increase in G causes an equal increase in Y:Y = G. • But Y  C  furtherY  furtherC  furtherY • So the final impact on income is much bigger than the initial G. CHAPTER 9 Introduction to Economic Fluctuations

  23. E E =Y E =C1+I +G E =C2+I +G At Y1, there is now an unplanned inventory buildup… C = MPC T Y E2 = Y2 E1 = Y1 Y An increase in taxes Initially, the tax increase reduces consumption, and therefore E: …so firms reduce output, and income falls toward a new equilibrium CHAPTER 9 Introduction to Economic Fluctuations

  24. Solving for Y eq’m condition in changes Iand G exogenous Solving for Y : Final result: CHAPTER 9 Introduction to Economic Fluctuations

  25. The tax multiplier def: the change in income resulting from a $1 increase in T : If MPC = 0.8, then the tax multiplier equals CHAPTER 9 Introduction to Economic Fluctuations

  26. The tax multiplier …is negative:A tax increase reduces C, which reduces income. …is greater than one (in absolute value): A change in taxes has a multiplier effect on income. …is smaller than the govt spending multiplier:Consumers save the fraction (1 – MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G. CHAPTER 9 Introduction to Economic Fluctuations

  27. The IS curve def: a graph of all combinations of r and Y that result in goods market equilibrium i.e. actual expenditure (output) = planned expenditure The equation for the IS curve is: CHAPTER 9 Introduction to Economic Fluctuations

  28. E I Y r Y Deriving the IS curve E =Y E =C +I(r2)+G r  I E =C +I(r1)+G  E  Y Y1 Y2 r1 r2 IS Y1 Y2 CHAPTER 9 Introduction to Economic Fluctuations

  29. Why the IS curve is negatively sloped • A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending (E). • To restore equilibrium in the goods market, output (a.k.a. actual expenditure, Y) must increase. CHAPTER 9 Introduction to Economic Fluctuations

  30. r r S2 S1 I(r) Y S, I Y2 Y1 The IScurve and the loanable funds model (a) The L.F. model (b) The IScurve r2 r2 r1 r1 IS CHAPTER 9 Introduction to Economic Fluctuations

  31. Fiscal Policy and the IS curve • We can use the IS-LM model to see how fiscal policy (G and T) affects aggregate demand and output. • Let’s start by using the Keynesian cross to see how fiscal policy shifts the IS curve… CHAPTER 9 Introduction to Economic Fluctuations

  32. E Y r Y Y Shifting the IScurve: G E =Y E =C +I(r1)+G2 At any value of r, G  E  Y E =C +I(r1)+G1 …so the IS curve shifts to the right. Y1 Y2 The horizontal distance of the IS shift equals r1 IS2 IS1 Y1 Y2 CHAPTER 9 Introduction to Economic Fluctuations

  33. The Theory of Liquidity Preference • Due to John Maynard Keynes. • A simple theory in which the interest rate is determined by money supply and money demand. CHAPTER 9 Introduction to Economic Fluctuations

  34. Money supply r interest rate The supply of real money balances is fixed: M/P real money balances CHAPTER 9 Introduction to Economic Fluctuations

  35. Money demand r interest rate Demand forreal money balances: L(r) M/P real money balances CHAPTER 9 Introduction to Economic Fluctuations

  36. Equilibrium r interest rate The interest rate adjusts to equate the supply and demand for money: r1 L(r) M/P real money balances CHAPTER 9 Introduction to Economic Fluctuations

  37. How the Fed raises the interest rate r interest rate To increase r, Fed reduces M r2 r1 L(r) M/P real money balances CHAPTER 9 Introduction to Economic Fluctuations

  38. CASE STUDY: Monetary Tightening & Interest Rates • Late 1970s:  > 10% • Oct 1979: Fed Chairman Paul Volcker announces that monetary policy would aim to reduce inflation • Aug 1979-April 1980: Fed reduces M/P 8.0% • Jan 1983:  = 3.7% How do you think this policy change would affect nominal interest rates? CHAPTER 9 Introduction to Economic Fluctuations

  39. The effects of a monetary tightening on nominal interest rates short run long run model prices prediction actual outcome Monetary Tightening & Rates, cont. Liquidity preference (Keynesian) Quantity theory, Fisher effect (Classical) sticky flexible i > 0 i < 0 8/1979: i= 10.4% 4/1980: i= 15.8% 8/1979: i= 10.4% 1/1983: i= 8.2%

  40. The LM curve Now let’s put Y back into the money demand function: The LMcurve is a graph of all combinations of r and Y that equate the supply and demand for real money balances. The equation for the LMcurve is: CHAPTER 9 Introduction to Economic Fluctuations

  41. r r LM L(r,Y2) L(r,Y1) Y M/P Y1 Y2 Deriving the LM curve (a) The market for real money balances (b) The LM curve r2 r2 r1 r1 CHAPTER 9 Introduction to Economic Fluctuations

  42. Why the LM curve is upward sloping • An increase in income raises money demand. • Since the supply of real balances is fixed, there is now excess demand in the money market at the initial interest rate. • The interest rate must rise to restore equilibrium in the money market. CHAPTER 9 Introduction to Economic Fluctuations

  43. r r LM2 LM1 L(r,Y1) Y M/P Y1 How M shifts the LM curve (a) The market for real money balances (b) The LM curve r2 r2 r1 r1 CHAPTER 9 Introduction to Economic Fluctuations

  44. LM r r1 IS Y1 Y Policy analysis with the IS-LM model We can use the IS-LM model to analyze the effects of • fiscal policy: G and/or T • monetary policy: M CHAPTER 9 Introduction to Economic Fluctuations

  45. LM r r2 r1 IS2 IS1 Y1 Y2 Y 2. 1. 3. An increase in government purchases 1. IS curve shifts right causing output & income to rise. 2. This raises money demand, causing the interest rate to rise… 3. …which reduces investment, so the final increase in Y CHAPTER 9 Introduction to Economic Fluctuations

  46. LM r r2 1. 2. r1 1. IS2 IS1 Y1 Y2 Y 2. 2. A tax cut Consumers save (1MPC) of the tax cut, so the initial boost in spending is smaller for T than for an equal G… and the IS curve shifts by …so the effects on rand Y are smaller for T than for an equal G. CHAPTER 9 Introduction to Economic Fluctuations

  47. LM1 r LM2 r1 r2 IS Y2 Y1 Y Monetary policy: An increase in M 1. M > 0 shifts the LM curve down(or to the right) 2. …causing the interest rate to fall 3. …which increases investment, causing output & income to rise. CHAPTER 9 Introduction to Economic Fluctuations

  48. Interaction between monetary & fiscal policy • Model: Monetary & fiscal policy variables (M, G, and T) are exogenous. • Real world: Monetary policymakers may adjust Min response to changes in fiscal policy, or vice versa. • Such interaction may alter the impact of the original policy change. CHAPTER 9 Introduction to Economic Fluctuations

  49. The Fed’s response to G > 0 • Suppose Congress increases G. • Possible Fed responses: 1.hold M constant 2.hold r constant 3.hold Y constant • In each case, the effects of the Gare different: CHAPTER 9 Introduction to Economic Fluctuations

  50. LM1 r r2 r1 IS2 IS1 Y1 Y2 Y Response 1: Hold M constant If Congress raises G, the IS curve shifts right. If Fed holds M constant, then LM curve doesn’t shift. Results: CHAPTER 9 Introduction to Economic Fluctuations

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