Goods & Financial Markets: The IS-LM Model

1. Goods & Financial Markets: The IS-LM Model The IS-LM Model The determination of output and interest rates in the short-run

2. Goods & Financial Markets: The IS-LM Model The goods market and the IS relation • Equilibrium in the goods market:Production (Y) = Demand (Z) • Or Investment = Saving  “IS” Relation • Demand (Z)= C+I+G C=C(Y-T) T & G are given • Now letInvestment depend on the level of sales (Y) and the interest rate (i):

3. Supply of Goods Demand for Goods (Z) Goods & Financial Markets: The IS-LM Model The IS curve Equilibrium: In the goods market, the higher the interest rate, the lower is investment and the lower is equilibrium output.

4. i IS (T) IS´ (T´ > T) Y Y´ Goods & Financial Markets: The IS-LM Model The IS curve Shifts in the IS Curve: An increase in taxes shifts the IS curve to the left Interest Rate, i Output, Y

5. i IS´ (G´ > G) IS (G) Y´ Y Goods & Financial Markets: The IS-LM Model The IS curve Shifts in the IS Curve: An increase in G shifts the IS curve to the right Interest Rate, i Output, Y

6. Goods & Financial Markets: The IS Curve Shifts in the IS curve What do you think: How would a decrease in consumer confidence shift the IS curve?

7. Financial Markets and the LM Relation Money market equilibrium: Demand for liquidity (L) = Supply of Money (M) M = nominal money supply (controlled by the Central Bank) $YL(i) = Demand for money (function of nominal income and the interest rate) Equilibrium Interest Rate: M=$YL(i)

8. Real Income Real Money Supply =Real Money Demand: Y(L)i LM relation: Financial Markets and the LM Relation Real money, real income, and the interest rate

9. Ms A´ i´ A i Md´ (for Y´ > Y) Md (for Y) M/P Financial Markets and the LM Relation An increase in demand for real balances: Increase in Y => increases Md which increases i Interest Rate, i (Real) Money, M/P

10. Ms LM (M/P) i´ A´ A´ i´ i A A i Md´ (for Y´ > Y) Md (for Y) M/P Y Y´ Financial Markets and the LM Relation The LM curve Interest Rate, i Interest Rate, i Income, Y (Real) Money, M/P

11. Ms´ b´ b´ a´ a´ Financial Markets and the LM Relation Shifts in the LM Curve: Showing changes in M & P The LM curve Interest Rate, i LM (M/P) Ms LM´ (M´/P > M/P) i´ b b i´ Interest Rate, i i´2 i´2 a i a i Md´ (for Y´ > Y) i2 i2 Md (for Y) M/P M´/P Y Y´ Income, Y (Real) Money, M/P

12. The IS-LM Model Exercises Equilibrium Requires:

13. i & Y is the only interest rate, output combination that yields a simultaneous equilibrium in the goods and financial markets i The IS-LM Model Exercises The IS-LM Equilibrium Graphically LM Interest Rate, i IS Y Output, Y

14. A Scenario: The President and Congress agree on a policy to reduce the budget deficit by increasing taxes, while holding gov’t spending constant. Question: What impact will this fiscal contraction policy have on output and interest rates? What shifts? IS, LM or both? ANSWER: IS Fiscal Policy, Activity, and the Interest Rate

15. Fiscal Policy, Activity, and the Interest Rate The IS-LM Equilibrium Graphically • IS & LM: Before the tax increase • Equilibrium A: i & Y LM • IS´: After the tax increase • Would the tax increase change • LM? • Disequilibrium at i (F, A) after • tax increase Interest Rate, i A F • i´, Y´ New equilibrium A´ i A´ • The fiscal contraction lowered • interest and output i´ IS (T) IS´ (T´ > T) Y´ Y Output, Y

16. Fiscal Policy, Activity, and the Interest Rate Here’s one for the devil’s advocate… Is deficit reduction good or bad for investment? Interest rate falls  good for investment But Output falls  bad for investment

17. A Scenario: The Fed engages in monetary expansion, i.e., it increases the money supply through open market operations Question: What impact will the monetary expansion have on output and interest? What shifts? IS, LM, or both? ANSWER: LM Monetary Policy, Activity, and the Interest Rate Monetary Policy, Activity, and the Interest Rate

18. Monetary Policy, Activity, and the Interest Rate The IS-LM Equilibrium Graphically LM (M/P) LM´ (M´/P > M/P) • IS & LM: Before increasing M • Equilibrium A: i & Y Interest Rate, i B • LM´: After increasing M A i • Disequilibrium at i (A, B) A´ i´ • New equilibrium A´: i´ & Y´ • Monetary expansion • lowered i & increased Y IS Y Y´ Output, Y

19. Fiscal Policy and Monetary Policy: Activity and the Interest Rate The effects of fiscal and monetary policy

20. The policy dilemma of 1992: Record high federal budget deficit (4.5% of GNP) High unemployment and slow growth Deficit reduction reduces output Expansionary fiscal policy increases the deficit Deficit reduction and expansionary monetary policy Recall: Solution: Policy Mix Using a Policy Mix The Clinton-Greenspan Policy Mix

21. Using a Policy Mix The Clinton-Greenspan Policy Mix LM LM´ • IS & LM: Before policy changes • Equilibrium A: i & Y Interest Rate, i • IS´: After deficit reduced A • B equilibrium without monetary • expansion i B • LM´ after monetary expansion A´ • New equilibrium i´, Y´ i´ IS IS´ Y Y´ Output, Y

22. Using a Policy Mix The Clinton-Greenspan Policy Mix Observations: • Strong consumer confidence andstock market shifting IS from 1992to 1998 • The strong expansion automaticallyreduced the deficit (1% growth reducesthe deficit to GNP ratio by 0.5%)

23. 1991 1992 1993 1994 1995 1996 1997 1998 Budget surplus (% of GDP) (minus sign: deficit) GDP growth (%) Interest rate (%) -3.3 -4.5 -3.8 -2.7 -2.4 -1.4 -0.3 -0.8 -0.9 2.7 2.3 3.4 2.0 2.7 3.9 3.7 7.3 5.5 3.7 3.3 5.0 5.6 5.2 4.8 Using a Policy Mix The Clinton-Greenspan Policy Mix The U.S. Economy 1991-1998

24. Adding Dynamics Observations: • Changes in output adjust slowly to changes in the goods market (IS) • Interest rates adjust instantaneously to changes in the financial markets (LM)

25. LM´ B iB Output decreases slowly B Interest rates adjust instantaneously IS´ Yb Adding Dynamics Dynamics Graphically Adjusting to a monetary contraction Adjusting to a tax increase LM Interest Rate, i Interest Rate, i A´ iA iA IS A Ya Ya Output, Y Output, Y

26. Adding Dynamics The Dynamics of Monetary Contraction with IS-LM LM´ LM • A: Initial equilibrium (i & Y) A´´ i´´ Interest Rate, i • LM´: After reducing money • supply A´ i´ • i rises to i´´ A • Higher i reduces demand and • output slowly A´´ to A´ i • Equilibrium restored at A´: i´, Y´ IS Y´ Y Output, Y

27. Adding Dynamics A Summary • Monetary policy changes interest rates rapidly and output slowly • The Central Bank must consider the output lag when implementing monetary policy

28. Does the IS-LM Model Actually Capture What Happens in the Economy? The Empirical Effects of an Increase in the FederalFunds Rate

29. Does the IS-LM Model Actually Capture What Happens in the Economy? The Empirical Effects of an Increase in the FederalFunds Rate

30. Does the IS-LM Model Actually Capture What Happens in the Economy? The Empirical Effects of an Increase in the FederalFunds Rate

31. Does the IS-LM Model Actually Capture What Happens in the Economy? The Empirical Effects of an Increase in the FederalFunds Rate

32. Does the IS-LM Model Actually Capture What Happens in the Economy? The Empirical Effects of an Increase in the FederalFunds Rate

33. Does the IS-LM Model Actually Capture What Happens in the Economy? Summary The IS-LM model is consistent with economic observations The IS-LM model explains movements in economic activity over the short-run