Goods and Financial Markets: The IS-LM Model

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

Summary of Chapter 3 • Equilibrium in the goods market requires the condition that production (Y) be equal to the demand for goods (Z). This condition is IS relation. • We looked at the factors that moved equilibrium output. Simplification: Interest rate did not affect the demand for goods.

5-1 The Goods Market and the IS Relation Investment depends on two factors: • Sales: A firm facing an increase in sales needs to purchase new plant, equipment, or both to increase production. Thus, investment increases when sales increase. • The interest rate: An increase in the interest rate will increase the cost of borrowing. Thus, investment decreases when the interest rate increases. We assume that inventory investment is zero, so income equals sales.

With the revised investment function, goods market equilibrium condition becomes Demand for goods and services (the RHS of equation (5.2)) is no longer assumed to be linear. For a given value of the interest rate, demand is an increasing function of the output, for two reasons: Increase in output increase in income increase in disposable income increase in consumption increase in demand Increase in output increase in investment because of equation (5.1)

5-1 The Goods Market and the IS Relation Figure 5-1 Equilibrium in the Goods Market • The relationship between output and demand, given the interest rate is depicted by upward sloping curve ZZ. • The equilibrium is reached at the intersection of 45-degree line and ZZ.

5-1 The Goods Market and the IS Relation • Figure 5-2 The Derivation of the IS Curve • Suppose that the interest rate increases from i to i’ • A higher interest rate decreases investment and demand. • The demand curve shifts down. The new equilibrium output is lower. • The resulting relation between the interest rate and ouput is given in figure 5.2(b). • The higher interest rate is associated with a lower level of output.

5-1 The Goods Market and the IS Relation Figure 5-3 Shifts of the IS Curve Changes in factors that increase the demand for goods such as an increase in government spending, a decrease in taxes and an increase in consumer confidence, given the interest rate, shift the IS curve to the right.

Summary of Chapter 4 • The interest rate is determined by the equality of the supply of and the demand for money. • The Central Bank is controlling the supply of money, M, directly. • The demand for money depends on nominal income and the interest rate.

5-2 Financial Markets and the LM RelationReal Money, Real Income, and the Interest rate • Rewrite nominal income as PY (where P is the price level), and divide by P to derive the real money market equilibrium condition: • Real money supply is the money stock in terms of goods, not dollars and real money demand depends on real income, (that is income in terms of goods), and the interest rate.

5-2 Financial Markets and the LM Relation Figure 5-4 The Derivation of the LM Curve

5-2 Financial Markets and the LM Relation Figure 5-5 Shifts of the LM Curve LM curve represents the relationship between the interest rate and output given the nominal money stock, M, and the pricel level.

5-2 Financial Markets and the LM Relation • Equilibrium in financial markets implies that, for a given real money supply, an increase in the level of income, which increases the demand for money, leads to an increase in the interest rate. This relation is represented by the upward sloping LM (Liquidity-Money) curve. • An increase (decrease) in the money supply shifts the LM curve down (up).

5-3 Putting the IS and the LM Relations Together • The equilibrium values of i and Y are those that satisfy simultaneously the goods market equilibrium condition (equation (5.2)) and the money market equilibrium condition (equation (5.3)). • Graphically, these values are determined by the point of intersection of the IS and LM curves, as illustrated in Figure 5.1.

5-3 Putting the IS and the LM Relations Together Figure 5-6 The IS–LM Model

5-3 Putting the IS and the LM Relations Together • The Effect of an increase in taxes (Fiscal Contraction) • Step 1: The effect of the change on the goods market (IS curve) • Increase in taxes decrease in disposable income decrease in consumption decrease in output • At any interest rate higher taxes lead to lower output, shifting the IS curve to the left.

Fiscal Policy, Activity, and the Interest Rate Figure 5-7A The Effects of an Increase in Taxes (cont.)

Fiscal Policy, Activity, and the Interest Rate • Step 2: The effect of the change on the financial market (LM curve) • Because taxes do not appear in LM relation, they do not affect LM curve. • Step 3: Determination of equilibrium • The new equilibrium is at the intersection of new IS curve and the unchanged LM curve.

Fiscal Policy, Activity, and the Interest Rate Figure 5-7B The Effects of an Increase in Taxes (cont.)

Fiscal Policy, Activity, and the Interest Rate Figure 5-7C The Effects of an Increase in Taxes

Fiscal Policy, Activity, and the Interest Rate • Step 4: Tell the story in words • The increase in taxes lead to lower disposable income, which causes people to decrease consumption. This decrease in demand leads to a decrease in output and income. At the same time, the decrease in income reduces the demand for money, leading to a decrease in the interest rate. The decline in the interest rate reduces but does not completely offset the effect of higher taxes on the demand for goods. • Disposable income and consumption go down. On one hand, lower output leads to lower sales and lower investment. On the other hand, a lower interest rate leads to higher investment.

Monetary Policy, Activity, and the Interest Rate • Suppose that the CB increases money supply through an open market operation. Given the assumption that price level is fixed, real money supply also increases. The effects of an increase in money supply • Step 1: The effect on the goods market (IS curve): • The money supply does not appear in IS relation meaning that IS curve does not shift. • Step 2: The effect on the financial market (LM curve) : LM curve shifts downwards, reducing the interest rate at a given level of income.

Monetary Policy, Activity, and the Interest Rate Figure 5-8 The Effects of a Monetary Expansion

Monetary Policy, Activity, and the Interest Rate • Step 3: Determination of equilibrium • Step 4: Tell the story in words • The increase in money supply leads to a lower interest rate. The lower interest rate leads to an increase in investment and, in turn, to an increase in demand and output. • Disposable income and consumption go up. Because sales are higher and interest rate is lower, investment unambigiously goes up. • Monetary expansion is more investment friendly than a fiscal expansion.

5-3 Putting the IS and the LM Relations Together Table 5-1 The Effects of Fiscal and Monetary Policy

5-4 Using a Policy Mix • The combination of monetary and fiscal policies is known as the policy mix. • Sometimes, the right mix is to use the two policies in the same direction. • Sometimes, the right mix is to use the two policies in opposite directions. • Aim is to reduce budget deficit: fiscal contraction • Aim is to offset the decrease in demand resulting ftom this fiscal contraction: expansionary monetary policy

Focus: The U.S. Recession of 2001 Figure 1 The U.S. Growth Rate, 1999–1 to 2002–4

Focus: The U.S. Recession of 2001 Figure 2 The Federal Funds Rate, 1999–1 to 2002–4

Focus: The U.S. Recession of 2001 Figure 3 U.S. Federal Government Revenues and Spending (as Ratios to GDP), 1999–1 to 2002–4

Focus: The U.S. Recession of 2001 Figure 4 The U.S. Recession of 2001

5-5 How Does the IS-LM Model Fit the Facts? Figure 5-9 The Empirical Effects of an Increase in the Federal Funds Rate (cont.)

5-5 How Does the IS-LM Model Fit the Facts? Figure 5-9 The Empirical Effects of an Increase in the Federal Funds Rate

Goods and Financial Markets: The IS-LM Model