goods & financial markets: the is-lm model

IS-LM Slide #1Econ 302 Macroeconomic Analysis

Goods & Financial Markets: The Goods & Financial Markets: The IS-LMIS-LM Model Model

The IS-LM ModelThe IS-LM Model

The determination of output andinterest rates in the short-run


Equilibrium in the goods market:Production (Y) = Demand (Z)

Demand (Z)= C+I+GC=C(Y-T)T, I, & G are given

The goods market and the IS relationThe goods market and the IS relation


A ReviewA Review


Equilibrium: Y=C(Y-T)+I+G

Changes in C, I, & G impact the equilibrium Y



A Review (Continued)A Review (Continued)




Investment, sales, and the interest rateInvestment, sales, and the interest rate

Investment depends on:

The level of sales

The interest rate

Therefore:

),(

),(

iYII

),(

),(

iYII


The IS curveThe IS curve


),( iYII ),( iYII

GITYCY )( GITYCY )(Equilibrium:

GiYITYCY ),()( GiYITYCY ),()(

Supply ofGoods

Demand forGoods (Z)




Dem

and

, Z

Output, Y

45°

b

a

YY´

ZZ (i)

ZZ´ (i´ > i)

ZZ: Demand, a function ofY for given i

equilibrium at a, Y

ZZ´: Demand with higher i

equilibrium at b, Y´



Goods & Financial Markets: The Goods & Financial Markets: The IS-LMIS-LM Model ModelD

em

an

d,

Z

Output, Y

45°

YY´

ZZ (i)

ZZ´ (i´ > i)

Inte

res

t R

ate

, i

Output, Y

A

A

Y

i

A´A´

Y´

i´

IS


Observation:Observation:


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

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


i

Y

IS (T)



Output, Y

Inte

rest

Rat

e, iShifts in the IS Curve:

IS´ (T´ > T)

Y´

An increase in taxes shifts the IS curve to the left


IS (G)

Y

i



Output, Y

Inte

rest

Rat

e, i

Y´

IS´ (G´ > G)

Shifts in the IS Curve:

An increase in G shifts the IS curve to the right


Shifts in the IS curveShifts in the IS curve

Goods & Financial Markets: The Goods & Financial Markets: The IS IS CurveCurve

What do you think:What do you think:

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


Money market equilibrium revisitedMoney market equilibrium revisited

Financial Markets and the Financial Markets and the LMLM Relation Relation

Equilibrium Interest Rate:

M=$YL(i)Equilibrium Interest Rate:

M=$YL(i)

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

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


Real money, real income, and the interest rateReal money, real income, and the interest rate


Real IncomeP

YY

$)(

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

P

M

LM relation: iLYP

M)(


Md (for Y)

M/P

Ai

Ms

The LM curveThe LM curve


(Real) Money, M/P

Inte

rest

Rat

e, i

Increase in Y => increases Md which increases i

A´i´

Md´ (for Y´ > Y)


A´

Md´ (for Y´ > Y)

LM (M/P)

A A

Y

ii

Md (for Y)

M/P

Ms

i´A´

Y´

i´


Financial Markets and the Financial Markets and the LMLM Relation RelationIn

tere

st

Ra

te,

i

(Real) Money, M/P

Interest Rate, i

Income, Y




Shifts in the LM Curve: Showing changes in M & P

Inte

res

t R

ate

, i

(Real) Money, M/P

b

a

M/P

LM (M/P)Interest Rate, i

Income, Y

a

b

Y´Y

i

i´

Md (for Y)

i

i´

Ms

Md´ (for Y´ > Y)

M´/P

LM´ (M´/P > M/P)

i´2

i2

i´2

i2

Ms´

a´

b´

a´

b´


Equilibrium Requires:Equilibrium Requires:

The The IS-LMIS-LM Model Exercises Model Exercises

GiYITYCYIS ),()(:

)(: iYLP

MLM

LMISor


The IS-LM Equilibrium GraphicallyThe IS-LM Equilibrium Graphically

The The IS-LMIS-LM Model Exercises Model Exercises

Output, Y

Inte

rest

Rat

e, i

IS

Y

i

LM

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


Fiscal Policy, Activity, and the Interest RateFiscal Policy, Activity, and the Interest Rate

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

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

A Scenario:A Scenario: The Fed engages in monetary expansion, i.e., it increases the money supply through open market operations

Monetary Policy, Activity, and the Interest RateMonetary Policy, Activity, and the Interest Rate


The IS-LM Equilibrium GraphicallyThe IS-LM Equilibrium Graphically


Output, Y

Inte

rest

Rat

e, i

Y´

i´

LM (M/P)

Y

iA B

IS

A´

LM´ (M´/P > M/P)

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

• LM´: After increasing M

• Disequilibrium at i (A, B)

• New equilibrium A´: i´ & Y´

• Monetary expansion lowered i & increased Y


The effects of fiscal and monetary policyThe effects of fiscal and monetary policy


Shift in IS Shift in LM Movement in Output

Movement in Interest Rate

Increase in taxes left none down down

Decrease in taxes right none up up

Increase in spending right none up up

Decrease in spending

left none down down

Increase in money none down up down

Decrease in money none up down up


Using a Policy MixUsing a Policy Mix

Recall:Recall:Deficit reduction reduces output

Expansionary fiscal policy increases the deficit

Deficit reduction reduces output

Expansionary fiscal policy increases the deficit

The policy dilemma of 1992:

The policy dilemma of 1992:

Record high federal budget deficit (4.5% of GNP)

High unemployment and slow growth

The Clinton-Greenspan Policy MixThe Clinton-Greenspan Policy Mix

Solution: Policy MixSolution: Policy Mix

Deficit reduction and expansionary monetary policyDeficit reduction and expansionary monetary policy



The Clinton-Greenspan Policy MixThe Clinton-Greenspan Policy Mix

Output, Y

Inte

rest

Rat

e, i

Y´

i´

LM

Y

i B

A

IS´

A´

LM´

• IS & LM: Before policy changes Equilibrium A: i & Y

• IS´: After deficit reduced

• B equilibrium without monetary expansion

• LM´ after monetary expansion

• New equilibrium i´, Y´ IS



German Unification & the German Monetary Fiscal Tug-of-WarGerman Unification & the German Monetary Fiscal Tug-of-War

The Scenario:The Scenario:

• Prior to unification, West Germany was exhibiting strong growth, investment

• After unification, strong fiscal stimulus from increased governmental spending on infrastructure and slow investment growth.




Output, Y

Inte

rest

Rat

e, i

Y´

i´

LM

Y

iA

IS´

A´

LM´

• A (i, Y) pre-unification equilibrium

• IS´: Post-unification IS

• LM´: Post-unification LM: Reduction in M to offset IS expansion

• A´(i´, Y´) post-unification equilibrium

IS




The West German Economy, 1998-1991The West German Economy, 1998-1991

1988 1989 1990 1991

BDGP growth (%) 3.7 3.8 4.5 3.1Investment*growth (%) 5.9 8.5 10.5 6.7Budget surplus (% of GDP) -2.1 0.2 -1.8 -2.9 (minus sign: deficit)Interest rate (short term) 4.3 7.1 8.5 9.2


Adding DynamicsAdding Dynamics

Observations: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´


Dynamics GraphicallyDynamics Graphically

Inte

res

t R

ate

, i

Output, Y

A´

Ya

LM

Inte

res

t R

ate

, i

Output, Y

A

B

Ya

iA

IS´

iA

B

IS

Yb

Interest ratesadjust

instantaneously

Outputdecreases

slowly

Adjusting to atax increase

Adjusting to amonetary contraction

iB



The Dynamics of Monetary Contraction with IS-LMThe Dynamics of Monetary Contraction with IS-LM

Output, Y

Inte

rest

Rat

e, i

Y´

i´

LM

Y

iA

A´

IS

A´´

LM´

• A: Initial equilibrium (i & Y)

• LM´: After reducing money supply

• i rises to i´´

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

• Equilibrium restored at A´: i´, Y´

i´´



A SummaryA Summary

•Monetary policy changes interest rates rapidly and output slowly

•The Central Bank must consider the output lag when implementing monetary policy

•Monetary policy changes interest rates rapidly and output slowly

•The Central Bank must consider the output lag when implementing monetary policy


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

Does the IS-LM model pass two tests?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 FederalFunds RateThe Empirical Effects of an Increase in the FederalFunds Rate



The IS-LM model is consistent with economic observations

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

The IS-LM model is consistent with economic observations

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

SummarySummary

goods & financial markets: the is-lm model

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