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IS-LM model and AD-AS model

0VS452 + 5EN253 Lecture 8 (part II) + Lecture 9. IS-LM model and AD-AS model. Eva Hrom á dkov á , 12.4 2010 + 19.4 2010. Overview of Lecture 8 – part II. IS-LM model of AD curve: Model for AD curve => analysis of stabilization policies IS curve – goods market

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IS-LM model and AD-AS model

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  1. 0VS452 + 5EN253 Lecture 8 (part II) + Lecture 9 IS-LM model andAD-AS model Eva Hromádková, 12.4 2010 + 19.4 2010

  2. Overview of Lecture 8 – part II IS-LM model of AD curve: • Model for AD curve => analysis of stabilization policies • IS curve – goods market • Fiscal policy – expenditures and taxes • LM curve – money market • Monetary policy – money supply • Equilibrium – interest rates (slides by Ron Cronowich)

  3. IS-LM modelContext • We have already introduced the model of aggregate demand (QTM) and aggregate supply. • Long run • prices flexible • output determined by factors of production & technology • unemployment equals its natural rate • Short run • prices fixed • output determined by aggregate demand • unemployment is negatively related to output

  4. IS-LM modelContext II • Today we will develop IS-LM model, the theory that explains the aggregate demand curve • First, we focus on the short run and assume hat price level is fixed • Then, we allow price to be flexible, and derive AD curve • Finally, we analyze the effect of fiscal and monetary policy on the most important macroeconomic aggregates – output and unemployment

  5. IS curveKeynesian 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

  6. IS curveElements of the Keynesian cross Consumption function: C = Ca + MPC*(Y-T) Govt. policy variables: G, T Investment: I = I(r) Planned expenditure: E = C(Y-T) + I(r) + G (aggregate demand) Equilibrium: Y = E

  7. E =C +I +G Slope is MPC IS curveGraphing planned expenditure E planned expenditure income, output,Y

  8. E =Y IS curveGraphing the equilibrium condition E planned expenditure 45º income, output,Y

  9. IS curveEquilibrium value of income E planned expenditure E>Y: depleting inventories => produce more E<Y: accumulating inventories=> produce less E =Y E<Y E>Y income, output,Y

  10. IS curveFiscal policy • Fiscal stimulus: • Increase in government expenditures • Cut taxes • Increase transfer payments • Fiscal restraint: • Decrease in government expenditures • Increased taxes • Decreased transfer payments

  11. E E =C +I +G2 E =C +I +G1 G Y E1 = Y1 E2 = Y2 Y IS curveIncrease in government purchases E =Y Looks like Y>G

  12. IS curveWhy is change in Y > change in G? • Def: Government purchases multiplier: • Initially, the increase in G causes an equal increase in Y:Y = G. • But Y  C (Y-T)  furtherY  furtherC  furtherY • So the government purchases multiplier will be greater than one.

  13. IS curveChange in G - Sum up changes in expenditure

  14. 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 IS curveIncrease in taxes …so firms reduce output, and income falls toward a new equilibrium

  15. IS curveChange in T - Sum up changes in expenditure equilibrium condition in changes I and G exogenous Solving for Y : Final result:

  16. IS curveTax multiplier Question: how is this different from the government spending multiplier considered previously? The tax multiplier: …is negative:An increase in taxes reduces consumer spending, which reduces equilibrium income. …is smaller than the govt spending multiplier:(in absolute value) 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.

  17. IS curveHow to derive the IS curve I 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 IScurve is: Y = C(Y-T) + I(r) + G The IScurve is negatively sloped. Intuition: 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.

  18. E I Y r Y IS curveHow to derive the IS curve II E =Y r  I E =C +I(r2)+G E =C +I(r1)+G  E  Y Y1 Y2 r1 r2 IS Y1 Y2

  19. E Y r Y Y IS curveFiscal policy and IS curve – example of increase in G E =C +I(r1)+G2 At given value of r, G  E  Y 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

  20. LM curveHow to build the LM curve The theory of liquidity preference: • Developed by John Maynard Keynes. • A simple theory in which the interest rate is determined by money supply and money demand.

  21. LM curveMoney supply r interest rate The supply of real money balances is fixed. M/P real money balances

  22. LM curveMoney demand r interest rate The demand for real money balances is negatively dependent on interest rate. L(r,Y) M/P real money balances

  23. LM curveEquilibrium r interest rate The interest rate adjusts to equate the supply and demand for money r1 L(r,Y) M/P real money balances

  24. LM curveMonetary policy – How can CB affect the interest rate? r interest rate To reduce r, central bank reduces M. In reality, this is hardly he case. More used technique = change of discount rate. r2 r1 L(r ,Y) M/P real money balances

  25. LM curveHow to derive LM curve? 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: The LMcurve is positively sloped. Intuition: 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.

  26. r r LM2 LM1 L(r,Y1) Y M/P Y1 LM curveHow to derive LM curve II (b) The LM curve (a) The market for real money balances r2 r2 r1 r1

  27. LM r IS Y IS-LM modelEquilibrium The short-run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods & money markets: Equilibrium interest rate Equilibrium level of income

  28. LM r r2 r1 IS2 IS1 Y1 Y2 Y 2. 1. 3. IS-LM modelFiscal policy:Anincrease in government purchases 1.IScurve 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

  29. LM r r2 1. 2. r1 1. IS2 IS1 Y1 Y2 Y 2. 2. IS-LM modelFiscal policy: A tax cut Because consumers save (1MPC) of the tax cut, the initial boost in spending is smaller for T than for an equal G… and the IS curve shifts by …so the effects on r and Y are smaller for a T than for an equal G.

  30. LM1 LM2 r r1 r2 IS Y2 Y1 Y IS-LM modelMonetary Policy: an increase in M 1. M > 0 shifts the LMcurve down(or to the right) 2. …causing the interest rate to fall 3. …which increases investment, causing output & income to rise.

  31. IS-LM modelShocks I LMshocks: exogenous changes in the demand for money. Examples: • a wave of credit card fraud increases demand for money • more ATMs or the Internet banking reduce money demand

  32. IS-LM modelShocks II ISshocks: exogenous changes in the demand for goods & services. Examples: • stock market boom or crash change in households’ wealth  C • change in business or consumer confidence or expectations  I and/or C

  33. IS1 IS2 LM r 2 2’ LM’ 1 Y1 Y2 Y2’ IS-LM modelWhen is fiscal policy more effective? Fiscal policy is effective (Y will rise much) when: LM flatter As the rise in G raises Y, the increase in money demand does not raise r much: so investment is not crowded out as much.

  34. 2’ Y2’ IS-LM ModelWhen is monetary policy more effective? Monetary policy is effective (Y will rise much) when: IS flatter r As a rise in M lowers the interest rate (r), investment rises more in response to the fall in r, so output rises more. IS LM1 LM2 1 2 IS’ Y1 Y2

  35. Aggregate demandHow to get from IS-LM to AD • So far, we’ve been using the IS-LMmodel to analyze the short run, when the price level is assumed fixed. • However, a change in P would shift the LMcurve and therefore affect Y. • The aggregate demand curve(introduced in chap. 9 ) captures this relationship between P and Y

  36. r P LM(P2) LM(P1) r2 r1 IS Y Y P2 P1 Aggregate demandHow to get from IS-LM to AD II Intuition for slope of ADcurve: P  (M/P)  LMshifts left  r  I  Y Y1 Y2 AD Y2 Y1

  37. P r LM(M1/P1) LM(M2/P1) r1 r2 IS Y Y Y2 Y1 P1 AD2 AD1 Y1 Y2 Aggregate demandEffect of monetary policy The Fed can increase aggregate demand: M  LMshifts right  r  I  Y at each value of P

  38. r P LM r2 r1 IS2 IS1 Y Y Y2 Y1 P1 AD2 AD1 Y1 Y2 Aggregate demandEffect of fiscal policy Expansionary fiscal policy (G and/or T ) increases agg. demand: T  C  IS shifts right  Y at each value of P

  39. IS-LM and AD-AS modelcombination of short & long run In the short-run equilibrium, if then over time, the price level will rise fall remain constant

  40. LRAS r P LM(P1) IS1 IS2 Y Y LRAS SRAS1 P1 AD1 AD2 IS-LM and AD-AS modelshort & long run effect of IS shock I A negative ISshock shifts ISand ADleft, causing Y to fall.

  41. LRAS r P LM(P1) IS2 Y Y SRAS1 P1 AD2 IS-LM and AD-AS modelshort & long run effect of IS shock II In the new short-run equilibrium, IS1 LRAS AD1

  42. LRAS r P LM(P1) IS2 Y Y SRAS1 P1 AD2 IS-LM and AD-AS modelshort & long run effect of IS shock II In the new short-run equilibrium, IS1 Over time, P gradually falls, which causes • SRAS to move down • M/P to increase, which causes LMto move down LRAS AD1

  43. LRAS r P LM(P2) IS2 Y Y SRAS2 P2 AD2 IS-LM and AD-AS modelshort & long run effect of IS shock III LM(P1) IS1 Over time, P gradually falls, which causes • SRAS to move down • M/P to increase, which causes LMto move down LRAS SRAS1 P1 AD1

  44. LRAS P r LM(P2) IS2 Y Y SRAS2 P2 AD2 IS-LM and AD-AS modelshort & long run effect of IS shock IV LM(P1) This process continues until economy reaches a long-run equilibrium with IS1 LRAS SRAS1 P1 AD1

  45. Unemployment (right scale) Real GNP(left scale) The Great DepressionCASE STUDY

  46. The Great DepressionCASE STUDY • Real side of economy: • Output: falling • Consumption: falling • Investment: falling much • Gov. purchases: fall (with a delay)

  47. The Great DepressionCASE STUDY • Nominal side: • Nominal interest rate: falling • Money supply (nominal): falling • Price level: falling (deflation)

  48. The Great DepressionCASE STUDY The Spending Hypothesis: Shocks to the IS Curve • asserts that the Depression was largely due to an exogenous fall in the demand for goods & services -- a leftward shift of the IScurve • evidence: output and interest rates both fell, which is what a leftward ISshift would cause

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