FIN 30220: Macroeconomic Analysis

1. FIN 30220: Macroeconomic Analysis Putting it all together: IS-LM-FE

2. Analyzing the Macro economy is all about understanding the interaction between three markets Labor markets determine employment, wages and income Capital markets determine investment, savings, and interest rates (expenditures) Money markets determine prices (long run) and interest rates (short run)

3. For instance, suppose a permanent productivity improvement hits the economy Labor demand increases while labor supply drops, raising wages and income (the effect on employment is ambiguous) Investment increases – interest rates rise Prices need to adjust to equate the interest rate in the money market with that in the capital market…here no price adjustment is needed Higher income increases money demand – interest rates rise

4. Suppose that the productivity improvement was only temporary… The productivity improvement raises wages and employment… Higher income raises money demand Temporarily higher income raises savings Oops! We have a problem…how can interest rates go up in one market and the other?

5. The productivity improvement raises wages and employment… Price falls Temporarily higher income raises savings Unless the Fed changes the money supply, we need a drop in the price level to increase the real value of money

6. Suppose that the Fed increases the money supply A change in money supply has no effect on labor demand or supply A change in money supply has no effect on savings or investment Again, we have a mismatch between the capital market and money market..the price needs to rise! An increase in the money supply lowers interest rates

7. IS-LM-FE Analysis is a compact representation of this three market model FE IS Labor markets determine employment, wages and income Capital markets determine investment, savings, and interest rates Money markets determine prices (long run) and interest rates (short run) LM

8. First, lets look at the labor market. The FE curve describes the long run equilibrium in the labor market. It is vertical at the full employment level of output (which is independent of the interest rate)

9. Anything that raises (lowers) production shifts the FE curve to the right (left). In a previous example, an increase in productivity increased output and employment. This would be a rightward FE shift

10. Now, onto capital markets The IS curve plots this current output/interest rate relationship implied by capital markets All else equal, higher levels of current output should be associated with higher savings and, hence, lower interest rates.

11. Anything that raises (lowers) interest rates in capital markets (other than a change in current output) shifts the IS curve right (left) Interest rates are higher due to higher investment demand – IS shifts right For example, a permanent increase in productivity raises investment (as well as current income).

12. Lastly, we have money markets If output increases, demand for real money rises. Without an increase in real supply, interest rates will have to rise The LM curve plots the output/interest rate relationship implied by money markets

13. Anything that raises (lowers) interest rates in money markets (other than a change in income) shifts the LM curve left (right) The LM curve shifts right in the short run (real money increases) In the example where money supply was increased, an increase in the money supply lowered interest rates in the short run

14. Put together, the IS-LM-FE diagram relates equilibrium conditions in all three markets on one convenient picture! FE describes long run full employment output LM describes long run/short run equilibria in money markets IS describes long run/short run equilibria in capital markets

15. The IS-LM-FE diagram relates equilibrium relationships in all three markets between current real GDP and the current real interest rate. FE describes long run full employment output LM describes equilibrium relationships in the money market – higher real GDP raises money demand which increases the interest rate – hence, the upward slope IS describes equilibrium relationships in the capital market – higher real GDP raises savings which decreases the interest rate – hence, the downward slope

16. Lets look at a temporary productivity improvement. IS-LM-FE is describing the same events and so we better get the same results. Short Run 1 Increased productivity raises employment and output – FE shifts right 1 3 2 The temporary rise in income raises savings which lowers the interest rate – IS DOES NOT SHIFT!! Long Run 3 Prices need to fall so that the interest rate in the money market and capital market match up. The will be our new long run output

17. Lets look at a permanent productivity improvement. IS-LM-FE is describing the same events and so we better get the same results. Short Run 1 Increased productivity raises employment and output – FE shifts right 1 3 2 The increase in investment raises interest rates – IS shifts right 2 Long Run 3 In this example, prices need to fall so that the interest rate in the money market and capital market match up. The will be our new long run output

18. Lets look at a money supply shock. IS-LM-FE is describing the same events and so we better get the same results. Short Run Money has no effect on labor market decisions – FE Doesn’t shift 1 Money has no impact on capital market decisions – IS doesn’t shift 3 2 Increased money supply lowers the interest rate – LM shifts right 3 Long Run prices need to rise so that the interest rate in the money market and capital market match up.

19. We can represent these relationships numerically…

20. First, we need to find the long run equilibrium for this economy. For this, we can temporarily ignore the LM sector… The FE curve represents long run output…plug this into the IS curve

21. Now that we know the interest rate and output, we can add the money market Plug in values for output and the interest rate Now, solve for real money Now, any value for money supply implies a unique price level

22. So, we have the economy’s long run equilibrium…now, lets give the economy a shock! Let’s increase the money supply by $10B

23. On impact, this shock only effects the money market…initially, the price level is fixed Assuming that output remained at 5,000, the interest rate would need to drop to 2.75% to get people willing to hold the extra cash But, at an interest rate of 2.75%, demand for goods and services would be $8,725!!

24. In the short run, we find a compromise…an interest rate where both money demand = money supply and where demand = supply (for goods & services) Plug one into the other to solve for r Now, find Y This would be the short term equilibrium…

25. Eventually, we need to return to the long run production level given by the FE sector…to accomplish this, a price increase will lower the real value of money and bring interest rates back up To return demand back to 5,000, r = 4% Long run output is 5,000 This would be the short term equilibrium…

26. Let’s look at what is going on in the background…

27. Let’s try another one…. Suppose we have a temporary productivity shock…output temporarily increases by 10%

28. Let’s try another one….again, prices are initially fixed The interest rate would need to rise to 14% to clear the money market The interest rate would need to fall to 3.5% to clear the goods market Now what???

29. Let’s try another one….again, prices are initially fixed An increase in the real value of money will bring the interest rate down A price level of 1.98 will lower the interest rate to 3.5%

30. Again, here’s what’s going on behind the scenes…

31. Let’s try one more…how about a demand shock. Consider a shock that (at the initial interest rate, increases investment demand by 10%)

32. Let’s try one more…how about a demand shock (i.e. a rise in investment demand). Given the demand shock, the interest rate would need to rise to 4.5% to keep demand at 5,000 At an interest rate of 4.5 (and output equal to 5,000), real money demand is 384, but real money supply is 386

33. Again, in the short run, we need a compromise… Plug one into the other to solve for r Now, find Y

34. Again, it will be a change in the price level that returns us to capacity An decrease in the real value of money will bring the interest rate up to 4.5% A price level of 2.21 will raise the interest rate to 4.5%

35. Again, behind the scenes…