Goods & Financial Markets: The IS-LM Model

1. Goods & Financial Markets: The IS-LM Model The IS-LM Model The determination of output and interest rates in the short-run

2. Goods & Financial Markets: The IS-LM Model The 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

3. Goods & Financial Markets: The IS-LM Model 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)

4. Goods & Financial Markets: The IS-LM Model The goods market and the IS relation Investment, sales, and the interest rate Investment depends on: The level of sales The interest rate Therefore:

5. Supply of Goods Demand for Goods (Z) Goods & Financial Markets: The IS-LM Model The IS curve Equilibrium:

6. Goods & Financial Markets: The IS-LM Model 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

7. A A´ i´ A´ A i Y´ Y Goods & Financial Markets: The IS-LM Model The IS curve ZZ (i) Demand, Z ZZ´ (i´ > i) Interest Rate, i IS Y Y´ Output, Y Output, Y

8. Goods & Financial Markets: The IS-LM Model Observation: In the goods market, the higher the interest rate, the lower the equilibrium output.

9. i IS (T) IS´ (T´ > T) Y Y´ Goods & Financial Markets: The IS-LM Model The IS curve Shifts in the IS Curve: An increase in taxes shifts the IS curve to the left Interest Rate, i Output, Y

10. i IS´ (G´ > G) IS (G) Y´ Y Goods & Financial Markets: The IS-LM Model The IS curve Shifts in the IS Curve: An increase in G shifts the IS curve to the right Interest Rate, i Output, Y

11. Goods & Financial Markets: The IS Curve Shifts in the IS curve What do you think: How would a decrease in consumer confidence shift the IS curve?

12. Financial Markets 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)

13. Real Income Real Money Supply =Real Money Demand: Y(L)i LM relation: Financial Markets and the LM Relation Real money, real income, and the interest rate

14. Ms A´ i´ A i Md´ (for Y´ > Y) Md (for Y) M/P Financial Markets and the LM Relation The LM curve Increase in Y => increases Md which increases i Interest Rate, i (Real) Money, M/P

15. Ms LM (M/P) i´ A´ A´ i´ i A A i Md´ (for Y´ > Y) Md (for Y) M/P Y Y´ Financial Markets and the LM Relation The LM curve Interest Rate, i Interest Rate, i Income, Y (Real) Money, M/P

16. Ms´ b´ b´ a´ a´ Financial Markets and the LM Relation 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

17. The IS-LM Model Exercises Equilibrium Requires:

18. i & Y is the only interest rate, output combination that yields a simultaneous equilibrium in the goods and financial markets i The IS-LM Model Exercises The IS-LM Equilibrium Graphically LM Interest Rate, i IS Y Output, Y

19. 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 rate? Fiscal Policy, Activity, and the Interest Rate Monetary Policy, Activity, and the Interest Rate

20. Fiscal 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

21. Fiscal Policy, Activity, and the Interest Rate The effects of fiscal and monetary policy

22. 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 Using a Policy Mix The Clinton-Greenspan Policy Mix

23. Using a 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

24. Using a Policy Mix German Unification & the German Monetary Fiscal Tug-of-War 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.

25. Using a Policy Mix German Unification & the German Monetary Fiscal Tug-of-War LM´ LM • A (i, Y) pre-unification • equilibrium A´ Interest Rate, i i´ • IS´: Post-unification IS • LM´: Post-unification LM: • Reduction in M to offset • IS expansion A i • A´(i´, Y´) post-unification • equilibrium IS´ IS Y Y´ Output, Y

26. The West German Economy, 1998-1991 1988 1989 1990 1991 BDGP growth (%) 3.7 3.8 4.5 3.1 Investment*growth (%) 5.9 8.5 10.5 6.7 Budget 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 Using a Policy Mix German Unification & the German Monetary Fiscal Tug-of-War

27. Adding Dynamics Observations: • Changes in output adjust slowly to changes in the goods market (IS) • Interest rates adjust instantaneously to changes in the financial markets (LM)

28. LM´ B iB Output decreases slowly B Interest rates adjust instantaneously IS´ Yb Adding Dynamics 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

29. 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 • Equilibrium restored at A´: i´, Y´ IS Y´ Y Output, Y

30. 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

31. 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?

32. Does the IS-LM Model Actually Capture What Happens in the Economy? The Empirical Effects of an Increase in the FederalFunds Rate Are the assumptions of IS-LM reasonable? Are the implications of IS-LM consistent with real-world observations?

33. Does the IS-LM Model Actually Capture What Happens in the Economy? Summary The IS-LM model is consistent with economic observations The IS-LM model explains movements in economic activity over the short-run