Understanding Economic Fluctuations: IS-LM Model Insights

1. 9. ISLM model CHAPTER 9 Introduction to Economic Fluctuations

2. In this lecture, you will learn… • an introduction to business cycle and aggregate demand • the IS curve, and its relation to • the Keynesian cross • the loanable funds model • the LM curve, and its relation to • the theory of liquidity preference • how the IS-LM model determines income and the interest rate in the short run when P is fixed CHAPTER 9 Introduction to Economic Fluctuations

3. Short run • In the following lectures, we will study the short-run fluctuations of the economy (business cycles) • We focus on three models: • ISLM model (lecture 9) • Mudell-Fleming model (lecture 10) • Model AS-AD • AD (lectures 9 and 10) • AS (lectures 11) CHAPTER 9 Introduction to Economic Fluctuations

4. Facts about the business cycle • GDP growth averages 3–3.5 percent per year over the long run with large fluctuations in the short run. • Consumption and investment fluctuate with GDP, but consumption tends to be less volatile and investment more volatile than GDP. • Unemployment rises during recessions and falls during expansions. • Okun’s Law: the negative relationship between GDP and unemployment. CHAPTER 9 Introduction to Economic Fluctuations

5. Time horizons in macroeconomics • Long run: Prices are flexible, respond to changes in supply or demand. • Short run:Many prices are “sticky” at some predetermined level. The economy behaves much differently when prices are sticky. CHAPTER 9 Introduction to Economic Fluctuations

6. When prices are sticky… …output and employment also depend on demand, which is affected by • fiscal policy (G and T ) • monetary policy (M ) • other factors, like exogenous changes in C or I. CHAPTER 9 Introduction to Economic Fluctuations

7. The Keynesian 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 CHAPTER 9 Introduction to Economic Fluctuations

8. Elements of the Keynesian Cross consumption function: govt policy variables: for now, plannedinvestment is exogenous: planned expenditure: equilibrium condition: actual expenditure = planned expenditure CHAPTER 9 Introduction to Economic Fluctuations

9. E =C +I +G MPC 1 Graphing planned expenditure E planned expenditure income, output,Y CHAPTER 9 Introduction to Economic Fluctuations

10. E =Y Graphing the equilibrium condition E planned expenditure 45º income, output,Y CHAPTER 9 Introduction to Economic Fluctuations

11. Equilibrium income The equilibrium value of income E planned expenditure E =Y E =C +I +G income, output,Y CHAPTER 9 Introduction to Economic Fluctuations

12. E At Y1, there is now an unplanned drop in inventory… E =C +I +G2 E =C +I +G1 G Y E1 = Y1 E2 = Y2 Y An increase in government purchases E =Y …so firms increase output, and income rises toward a new equilibrium. CHAPTER 9 Introduction to Economic Fluctuations

13. Solve for Y : Solving for Y equilibrium condition in changes because I exogenous because C= MPCY Collect terms with Yon the left side of the equals sign: CHAPTER 9 Introduction to Economic Fluctuations

14. The government purchases multiplier Definition: the increase in income resulting from a $1 increase in G. In this model, the govt purchases multiplier equals Example: If MPC = 0.8, then An increase in G causes income to increase 5 times as much! CHAPTER 9 Introduction to Economic Fluctuations

15. Why the multiplier is greater than 1 • Initially, the increase in G causes an equal increase in Y:Y = G. • But Y  C  furtherY  furtherC  furtherY • So the final impact on income is much bigger than the initial G. CHAPTER 9 Introduction to Economic Fluctuations

16. 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 An increase in taxes Initially, the tax increase reduces consumption, and therefore E: …so firms reduce output, and income falls toward a new equilibrium CHAPTER 9 Introduction to Economic Fluctuations

17. Solving for Y eq’m condition in changes Iand G exogenous Solving for Y : Final result: CHAPTER 9 Introduction to Economic Fluctuations

18. The tax multiplier def: the change in income resulting from a $1 increase in T : If MPC = 0.8, then the tax multiplier equals CHAPTER 9 Introduction to Economic Fluctuations

19. The tax multiplier …is negative:A tax increase reduces C, which reduces income. …is greater than one (in absolute value): A change in taxes has a multiplier effect on income. …is smaller than the govt spending multiplier: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. CHAPTER 9 Introduction to Economic Fluctuations

20. The IS curve 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 IS curve is: CHAPTER 9 Introduction to Economic Fluctuations

21. E I Y r Y Deriving the IS curve E =Y E =C +I(r2)+G r  I E =C +I(r1)+G  E  Y Y1 Y2 r1 r2 IS Y1 Y2 CHAPTER 9 Introduction to Economic Fluctuations

22. Why the IS curve is negatively sloped • 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. CHAPTER 9 Introduction to Economic Fluctuations

23. r r S2 S1 I(r) Y S, I Y2 Y1 The IScurve and the loanable funds model (a) The L.F. model (b) The IScurve r2 r2 r1 r1 IS CHAPTER 9 Introduction to Economic Fluctuations

24. Fiscal Policy and the IS curve • We can use the IS-LM model to see how fiscal policy (G and T) affects aggregate demand and output. • Let’s start by using the Keynesian cross to see how fiscal policy shifts the IS curve… CHAPTER 9 Introduction to Economic Fluctuations

25. E Y r Y Y Shifting the IScurve: G E =Y E =C +I(r1)+G2 At any value of r, G  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 CHAPTER 9 Introduction to Economic Fluctuations

26. Exercise: Shifting the IS curve • Use the diagram of the Keynesian cross or loanable funds model to show how an increase in taxes shifts the IS curve. CHAPTER 9 Introduction to Economic Fluctuations

27. The Theory of Liquidity Preference • Due to John Maynard Keynes. • A simple theory in which the interest rate is determined by money supply and money demand. CHAPTER 9 Introduction to Economic Fluctuations

28. Money supply r interest rate The supply of real money balances is fixed: M/P real money balances CHAPTER 9 Introduction to Economic Fluctuations

29. Money demand r interest rate Demand forreal money balances: L(r) M/P real money balances CHAPTER 9 Introduction to Economic Fluctuations

30. Equilibrium r interest rate The interest rate adjusts to equate the supply and demand for money: r1 L(r) M/P real money balances CHAPTER 9 Introduction to Economic Fluctuations

31. How the Fed raises the interest rate r interest rate To increase r, Fed reduces M r2 r1 L(r) M/P real money balances CHAPTER 9 Introduction to Economic Fluctuations

32. CASE STUDY: Monetary Tightening & Interest Rates • Late 1970s:  > 10% • Oct 1979: Fed Chairman Paul Volcker announces that monetary policy would aim to reduce inflation • Aug 1979-April 1980: Fed reduces M/P 8.0% • Jan 1983:  = 3.7% How do you think this policy change would affect nominal interest rates? CHAPTER 9 Introduction to Economic Fluctuations

33. The effects of a monetary tightening on nominal interest rates short run long run model prices prediction actual outcome Monetary Tightening & Rates, cont. Liquidity preference (Keynesian) Quantity theory, Fisher effect (Classical) sticky flexible i > 0 i < 0 8/1979: i= 10.4% 4/1980: i= 15.8% 8/1979: i= 10.4% 1/1983: i= 8.2%

34. The LM curve Now let’s put Y back into the money demand function: 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: CHAPTER 9 Introduction to Economic Fluctuations

35. r r LM L(r,Y2) L(r,Y1) Y M/P Y1 Y2 Deriving the LM curve (a) The market for real money balances (b) The LM curve r2 r2 r1 r1 CHAPTER 9 Introduction to Economic Fluctuations

36. Why the LM curve is upward sloping • 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. CHAPTER 9 Introduction to Economic Fluctuations

37. r r LM2 LM1 L(r,Y1) Y M/P Y1 How M shifts the LM curve (a) The market for real money balances (b) The LM curve r2 r2 r1 r1 CHAPTER 9 Introduction to Economic Fluctuations

38. LM r IS Y The short-run equilibrium 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 CHAPTER 9 Introduction to Economic Fluctuations

39. LM r r1 IS Y1 Y Policy analysis with the IS-LM model We can use the IS-LM model to analyze the effects of • fiscal policy: G and/or T • monetary policy: M CHAPTER 9 Introduction to Economic Fluctuations

40. LM r r2 r1 IS2 IS1 Y1 Y2 Y 2. 1. 3. An increase in government purchases 1. IS curve 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 CHAPTER 9 Introduction to Economic Fluctuations

41. LM r r2 1. 2. r1 1. IS2 IS1 Y1 Y2 Y 2. 2. A tax cut Consumers save (1MPC) of the tax cut, so the initial boost in spending is smaller for T than for an equal G… and the IS curve shifts by …so the effects on rand Y are smaller for T than for an equal G. CHAPTER 9 Introduction to Economic Fluctuations

42. LM1 r LM2 r1 r2 IS Y2 Y1 Y Monetary policy: An increase in M 1. M > 0 shifts the LM curve down(or to the right) 2. …causing the interest rate to fall 3. …which increases investment, causing output & income to rise. CHAPTER 9 Introduction to Economic Fluctuations

43. Interaction between monetary & fiscal policy • Model: Monetary & fiscal policy variables (M, G, and T) are exogenous. • Real world: Monetary policymakers may adjust Min response to changes in fiscal policy, or vice versa. • Such interaction may alter the impact of the original policy change. CHAPTER 9 Introduction to Economic Fluctuations

44. The Fed’s response to G > 0 • Suppose Congress increases G. • Possible Fed responses: 1.hold M constant 2.hold r constant 3.hold Y constant • In each case, the effects of the Gare different: CHAPTER 9 Introduction to Economic Fluctuations

45. LM1 r r2 r1 IS2 IS1 Y1 Y2 Y Response 1: Hold M constant If Congress raises G, the IS curve shifts right. If Fed holds M constant, then LM curve doesn’t shift. Results: CHAPTER 9 Introduction to Economic Fluctuations

46. LM1 r LM2 IS2 IS1 Y3 Y1 Y2 Y Response 2: Hold r constant If Congress raises G, the IScurve shifts right. To keep r constant, Fed increases Mto shift LM curve right. r2 r1 Results: CHAPTER 9 Introduction to Economic Fluctuations

47. LM2 LM1 r r3 r1 IS2 IS1 Y1 Y2 Y Response 3: Hold Y constant If Congress raises G, the IScurve shifts right. To keep Y constant, Fed reduces Mto shift LM curve left. r2 Results: CHAPTER 9 Introduction to Economic Fluctuations

48. Estimates of fiscal policy multipliers from the DRI macroeconometric model Estimated value of Y/G Estimated value of Y/T Assumption about monetary policy Fed holds money supply constant 0.60 0.26 Fed holds nominal interest rate constant 1.93 1.19 CHAPTER 9 Introduction to Economic Fluctuations

49. IS-LM and aggregate demand • 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 LM and therefore affect Y. • The aggregate demand curve(introduced in Chap. 9) captures this relationship between P and Y. CHAPTER 9 Introduction to Economic Fluctuations

50. r P LM(P2) LM(P1) r2 r1 IS Y Y P2 P1 Deriving the AD curve Intuition for slope of AD curve: P  (M/P)  LM shifts left  r  I  Y Y1 Y2 AD Y2 Y1 CHAPTER 9 Introduction to Economic Fluctuations