Lecture 19: The IS/LM Model (continued)

1. Lecture 19: The IS/LM Model (continued) Based Primarily on Mankiw Chapters 11

2. Review And Learning Objectives • In this lecture we will present the complete IS/LM model. • We will see how IS/LM can be used to explain the business cycle, and how it can answer fundamental questions about the effectiveness of fiscal and monetary policy. • We will also use the IS/LM model in order to give an alternative derivation of the AD (aggregate demand) curve. • We will also talk about the Great Depression.

3. Explaining Economic Fluctuations • The intersection of the IS curve and the LM curve determines the level of national income. • When one of these curves shifts, the short-run equilibrium of the economy changes, and national income fluctuates. • We will examine how changes in policy and shocks to the economy can cause these curves to shift. • We first consider fiscal policy and then monetary policy.

4. Fiscal Policy And IS/LM (1) • We begin by examining how changes in fiscal policy (taxes and spending) alter the economy’s short-run equilibrium. • An increase in government spending is represented in the next slide. • The equilibrium of the economy moves from point A to point B. Income rises from Y1 to Y2 and the real interest rate rises from r1 to r2. • When the government increases its spending, total income Y begins to rise (from the Keynesian cross model). As Y rises, the economy’s demand for money rises and so, assuming that the supply of real balances is fixed, the interest rate r begins to rise. As r rises, I falls thus partially offsetting the effects of the increased government spending.

6. Fiscal Policy And IS/LM (2) • The increased government spending has “crowded-out” some of the investment spending in the economy. • The case of a tax cut is similar. This is represented in the next slide.

8. Monetary Policy And IS/LM (1) • We now examine the effects of monetary policy. This is represented in the next slide. • Consider an increase in the money supply. An increase in M leads to an increase in M/P since we are assuming that P is fixed. The LM curve shifts downward and the economy moves from point A to point B. The increase in the money supply lowers the interest rate and raises the level of income. • This is because the increase in M/P lowers r and this causes I to increase since I is inversely related to r. This, in turn, increases planned expenditure, production and income Y. • This process is called the “monetary transmission mechanism”.

10. Fiscal And Monetary Interaction • We can now consider simultaneous fiscal and monetary policy in the IS/LM model. • Slide (a) shows the effects of a tax increase, holding the real money supply constant. • Slide (b) shows the effects of a tax increase, accompanied by a contraction in the real money supply. This keeps the interest rate constant in the economy. • Slide (c) shows the effect of the tax cut combined with an expansion of the real money supply. The effect of this policy is to keep the level of income constant in the economy.

12. Shocks And IS/LM • Shocks to the IS curve are exogenous changes in the demand for goods and services. • Keynes called self-fulfilling shocks to planned investment spending “animal spirits”. IS shocks may also arise from shocks to consumption demand. • Shocks to the LM curve arise from exogenous changes in the demand for money. For example, restrictions on credit card availability affect the amount of money people wish to hold. This would be an LM shock. • Both types of shocks are important.

13. IS/LM And Aggregate Demand • We can use IS/LM to provide another derivation of the AD curve. • Remember, in earlier lectures we derived this from the quantity theory of money. • The new derivation is explained in the next slide. • The effects of fiscal and monetary expansion on the economy are shown in slide 15. • This is why we say that IS/LM is a theory of aggregate demand determination. By this, we mean that the position of the AD curve is determined by the position of the economy’s IS curve and its LM curve.

16. IS/LM in the short-run and long-run • How does the economy make the transition from the short-run to the long-run? • In the Keynesian model of the economy, prices are stuck at P1. The short-run equilibrium of the economy is represented by point K. Output is below the natural rate, Y* (represented by the vertical LRAS curve). Over time, prices fall and so the LM curve shifts to the right. The economy moves down the AD curve from point K to point C. • In the long-run, after prices have adjusted, the economy returns to its natural rate of output. • We deal with this point mathematically in slide 18.

18. IS/LM and Neoclassical • IS/LM provides a useful way of thinking about the difference between the Keynesian and Neoclassical models of the economy. • IS curve: Y = C(Y-T) + I(r) + G • LM curve: M/P = L(r, Y) • We have two equations and three endogenous variables: Y, r and P. The exogenous variables are T, G and M. • Neoclassical approach: Y is fixed [Y* = F(K*, L*)]. We solve for equations for P and r. • Keynesian approach: P is fixed. We solve equations for r and Y.

19. The Great Depression (1) • Was the Great Depression caused by “shocks” to the IS curve or “shocks” to the LM curve? • The Spending Hypothesis • A collapse in spending caused the IS curve to shift to the left. • The stock market crash of 1929. This reduced wealth and increased uncertainty, inducing consumers to save more of their wealth and consume less. • Over-investment in 1920s led to a fall in investment. • Also, the fiscal policy measures in the U.S. in 1932 caused G to fall, exacerbating the leftward shift in the IS curve. • So there may be several things that explain the decline in spending.

20. The Great Depression (2) • The Money Hypothesis • Friedman and Schwartz argue that contraction in the money supply caused the LM curve to shift to the left. • Considerable empirical controversy over this claim. Evidence does not seem to support the hypothesis. The nominal money supply fell, but so did prices and thus real balances were unaffected. The LM curve should have remained constant. • Prices fell from 1929 to 1933 by 25%. • Controversy about the causes of the Great Depression continues today.