is-lm revisited d

8/2/2019 Is-LM Revisited d

1/22

IS-LM Revisited

Simple Income DeterminationProperties of IS & LM Curves

Equilibrium Output & Interest RatesEconomic Policy


2/22

(1) Simple Income Determination

* Eco 1002

* Goods Market (IS)

* Exogenous Interest Rate & Prices* Endogenous Income (GDP)

(2) IS-LM Model

* Eco 2101 (Keynesian Short-Run)

* (1) + Money Market

* Endogenous Income & Interest Rate (Fixed P)

Endogenous Policy


3/22

Simple Income Determination(Eco 1001)

Behavioral Assumptions:

Consumption = C (y, r)

y= disposable income = Y T

r = interest rateMPC = where 0 < Cy < 1

Investment = I(r)

Government Purchases = G

Exogenous: r, P, Fiscal Policy: G, T

Endogenous: Y

Linear Examples

yCyC /

0/ rIrI


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Equilibrium:

Some Basic Results:

(interest rates and GDP)

(Gov. Spending Multiplier)

(Tax Multiplier)

EGrIryCY )(),(

11

1/

yCdGdY

01

/

y

rr

CICdrdY

01

/

y

y

C

CdTdY


5/22

IS-LM Model (Eco 2101)

Goods & Money Market Equilibrium

IS-LM Model

Exogenous: P, Fiscal Policy: G, TMonetary Policy: Ms

Endogenous: Y and r


6/22

IS and the Goods Market

Goods Market Equilibrium:

Y = C(y,r) + I(r) + G (IS equation)

where y= Y T = disposable income0< Cy< 1

Ir < 0

G and T are exogenous policyvariables


7/22

Properties of IS curve:

Slope*:

Government spending multiplier:

(shifts right)

Tax Multiplier:

(shifts left)

01

y

rrIS

C

IC

dr

dY

11

1

yCdG

dY

01

y

y

C

C

dT

dY


8/22

LM and the Money Market

Real Money Demand = L(Y,r)

Money Market Equilibrium:

M

s

= P*L(Y,r) (LM equation)

Ms is an exogenous policy variable.

0/ YLYL

0/

rLrL


9/22

Properties of LM curve

Slope*:

Real Money Supply:

(shifts right)

0

Y

r

LM L

L

dr

dY

01

)(

r

sPLMd

dr


10/22

The Simple IS-LM Model - (Y,r) whichsolves:

(IS)

(LM)

GrIryCY )(),(

),(* rYLPMs


11/22

Policy in IS-LM Model

Exogenous: P

Endogenous: Y, r

Policy Variables: G, Ms, T

Fiscal Policy

(1) Government Expenditures (dG)

but less than 1/(1-Cy)!

0)/)(()1(

1

)()1(

*

rYrryrrYry

r

LLICCICLLC

L

dG

dY


12/22

Crowding-out effect!

Effectiveness of G:

If (IS Flat)

or (LM verticle)

then . (Complete crowding-out!)

(2) Taxes (dT): dY/dT = ?, dr/dT = ?

0)()1(

*

rrYry

Y

ICLLC

L

dG

dr

rr CI ,

0rL

0dG

dY


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Monetary Policy (dMs):

0

)()1(

*

rrYry

rr

s

ICPLPLC

CI

dM

dY

0)()1(

1*

rrYry

y

sICPLPLC

C

dM

dr


14/22

Effectiveness of monetary policy:

If (IS vertical)

or (LM flat)

Then

(Ineffective Monetary Policy)

0, rr CI

r

L

0sdM

dY


15/22

Liquidity Trap and Interest RateInsensitivity

Great Depression

Year UR i p r = i -p

1930 8.9 3.6 -2.6 6.2

1931 16.3 2.6 -10.1 12.71932 24.1 2.7 -9.3 12.0

1933 25.2 1.7 -2.2 3.4

1934 22.0 1.0 7.4 -6.61935 20.3 0.8 0.9 -0.1

1936 17.0 0.8 0.2 0.6


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2008-09 Recession

Jan 2007 Jan 2010, Federal funds ratecut from 6% to 1%.

i UR

Jan 2007 5.25% 4.6%

Jan 2008 3.94% 5%Jan 2009 0.15% 7.7%

Jan 2010 0.12% 10%


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Business Cycles in IS-LM

Shocks to Consumer confidence (g):

C = C(Y,r,g) where Cg > 0

dY*/dg > 0

dr*/dg 0

Shocks to money demand (s):

L = L(y,r,s) where Ls> 0

dY*/ds < 0

dr*/ds 0


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Endogenous Policy

Monetary/Fiscal Policy responds to economicconditions to achieve goal.

Objective: dY = 0 (output stability) OR

dr = 0 (interest rate stability)

Exogenous: Policies - Ms or G, or T

Shocksg or s

Endogenous: Policies - Ms or G, or T


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Example: An increase in G and Feds objective

is to keep r constant (prevent crowding out).

Step 1: Set dr = 0

Step 2: Treat dY and dMs as endogenous, dGas exogenous.

Step 3: Use Cramers Rule to solve for

dY/dG and dMs/dG.Suppose instead Fed wanted to keep outputstable (dY = 0). Find dr/dG and dMs/dG.


20/22

Evaluation of Simple Keynesian IS-LM Models

Provided reasonable explanation ofbusiness cycles.

Guides policymakers on stabilizingeconomic fluctuations.

Can be applied easily to think aboutcurrent events.


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Shortcomings

Criticisms of IS-LM Model:

(1) Emphasis on aggregate demand.

(2) Static Model.(3) Lack of solid microeconomic

foundations.

Lucas Critique on Policy Evaluation Examples: Consumption, Phillips Curve


22/22

Modern Macro

Dynamics

Expectations (rational)

Microeconomic Foundations

Most modern macro models (New Classical

and New Keynesian) have these features.

is-lm revisited d

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