Goods and Financial Markets: The IS-LM Model

1. Dr. Tufte's ECON 3020 using Blanchard's text. 1 Chapter 5 Goods and Financial Markets: The IS-LM Model

2. Dr. Tufte's ECON 3020 using Blanchard's text. 2 5-1 The Goods Market and the IS Relation Investment, Sales and the Interest Rate The IS Curve Shifts in the IS Curve

3. Dr. Tufte's ECON 3020 using Blanchard's text. 3 Investment, Sales and the Interest Rate Now we assume that investment depends negatively on the interest rate We also now assume that investment depends positively on income The latter is less important for building the model

4. Dr. Tufte's ECON 3020 using Blanchard's text. 4 The IS Curve Captures the Y = C + I + G relationship in output-interest rate space When interest rates fall, investment goes up, pushing income up as well, and vice versa So, the upward sloping line in income-output space means the same thing as a downward sloping curve in income-interest rate space

5. Dr. Tufte's ECON 3020 using Blanchard's text. 5 Shifts in the IS Curve Variables that shift the Y = C + I + G line up or down in income-output space, shift the IS in the same direction Increasing G shifts the Y = C + I + G line up, and the IS curve up as well, and vice versa Increasing I overbar shifts the Y = C + I + G line up, and the IS curve up as well, and vice versa Decreasing T shifts the Y = C + I + G line up, and the IS curve up as well, and vice versa

6. Dr. Tufte's ECON 3020 using Blanchard's text. 6 5-2 Financial Markets and the LM Relation Real Money, Real Income and the Interest Rate The LM Curve Shifts in the LM Curve

7. Dr. Tufte's ECON 3020 using Blanchard's text. 7 Real Money, Real Income and the Interest Rate We usually assume that the demand for nominal money moves in tandem with the price level This means the real money (M/P) is a useful variable to think about We also usually assume that your demand for real money moves in tandem with real GDP M/P = YL(i) We don�t lose anything by re-expressing our money supply and money demand graphs in terms of real rather than nominal money

8. Dr. Tufte's ECON 3020 using Blanchard's text. 8 The LM Curve Increases in income shift money demand to the right This increase interest rates The LM curve slopes upward to captures these effects in output-interest rate space

9. Dr. Tufte's ECON 3020 using Blanchard's text. 9 Shifts in the LM Curve The LM curve shifts in the same direction as real money Increases in nominal money increase real money too, and cause the LM to shift to the right, and vice versa Increases in prices decrease real money, and cause the LM to shift to the left, and vice versa

10. Dr. Tufte's ECON 3020 using Blanchard's text. 10 5-3 The IS-LM Model: Exercises Fiscal Policy, Activity, and the Interest Rate Monetary Policy, Activity and the Interest Rate

11. Dr. Tufte's ECON 3020 using Blanchard's text. 11 Fiscal Policy, Activity, and the Interest Rate Changes in government spending and taxes shift the IS Both are controlled by the government Movements in either or both are called fiscal policy Both can be summarized by thinking about G-T The deficit, output, and interest rates move together when the IS shifts

12. Dr. Tufte's ECON 3020 using Blanchard's text. 12 Monetary Policy, Activity and the Interest Rate Changes in money supply and prices shift the LM Only M is controlled by the central bank Changes in M are called monetary policy Central banks �target� interest rates, and the media focuses on this aspect rather than changes in M Money and interest rates move in opposite directions Prices and interest rates move together

13. Dr. Tufte's ECON 3020 using Blanchard's text. 13 5-4 Using a Policy Mix Policy is made by different agents Policies are sometimes (but not always) coordinated Maintaining the right level of output may not be the only goal Price stability (zero inflation) is another common goal The Clinton administration, congress, and the federal reserve under Alan Greenspan have coordinated policies for years Contractionary fiscal policy offset by expansionary monetary policy � both leading to low interest rates

14. Dr. Tufte's ECON 3020 using Blanchard's text. 14 5-5 Adding Dynamics Generally speaking, the market for macroeconomics stocks adjusts quickly, while the market for macroeconomic flows adjusts slowly We are always on the LM curve It can take time to move from one IS curve to another The economy can slide along the LM curve as the IS adjusts slowly

15. Dr. Tufte's ECON 3020 using Blanchard's text. 15 5-6 Does the IS-LM Model Actually Capture What Happens in the Economy? More complex econometric evidence suggests that it does It certainly seems to get the directions right The graphs on p. 97 suggest that the effects of policy build for about 4 quarters and then (for the most part) level off