IS-LM 2: Examples

1. IS-LM 2: Examples See Mankiw 12.1 & 12.3

2. LM r IS Y Recap: Equilibrium in IS-LM The IScurve represents equilibrium in the goods market. r1 The LMcurve represents money market equilibrium. Y1 The intersection determines the unique combination of Y and rthat satisfies equilibrium in both markets.

3. Policy & Shocks in ISLM • Fiscal policy: change G and/or T • Monetary Policy: Change M • Shocks to the economy • Great Depression • Recession of 2001 • Crisis of 2008-….

4. Fiscal Policy and Crowding out • Shift in the IS curve: G is in defn of IS • Shift along the LM curve: G is not in defn of LM • IS shifts to right: for any interest rate output will rise • Remember multiplier • Crowding out • Final DY is less then if we looked at goods market only • GYLrIY • Public expenditure replaces private investment LM r IS1 IS0 y

5. LM r r2 r1 IS2 IS1 Y1 Y2 Y 2. 1. 3. FP & Crowding out warning: v simple cons function 1. IS curve shifts right 2. This raises money demand, causing the interest rate to rise… 3. …which reduces investment, so the final increase in Y

6. 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.

7. Balanced Budget Multiplier • The expression for the multiplier is from a very simple model • But the general idea that tax multiplier is smaller than expenditure multiplier is true • Why? Savings • This implies that balanced budget multiplier is greater than zero. • In the very simple model it is 1

8. An Increase in Money Supply • Money supply affects LM direclty • Shift in LM along IS • LM shift: for any output level interest rates will fall • New eqm. has lower r and higher Y • There is a crowding out effect her also. • Dr less than if we looked at money market only • Y rises and puts extra demand for money • M -> r -> I -> Y -> L -> r LM1 r LM2 IS Y

9. 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 interactions may alter the impact of the original policy change.

10. LM1 r LM2 IS2 IS1 Y3 Y1 Y2 Y Change G & M: Extra effect If Gov raises G, the IScurve shifts right. To keep r constant, CB increases Mto shift LM curve right. r2 r1 Results: No Crowding out

11. LM2 LM1 r r3 r1 IS2 IS1 Y1 Y2 Y Change G & M: No effect on Y If Gov raises G, the IScurve shifts right. To keep Y constant, CB reduces Mto shift LM curve left. r2 Results: • complete CO • Why? Inflation • Example German unification

12. Estimates of fiscal policy multipliers Estimated value of Y/G Estimated value of Y/T from the DRI macroeconometric model of US Assumption about monetary policy Fed holds money supply constant 0.60 0.26 Fed holds nominal interest rate constant 1.93 1.19

13. Shocks to the Ecomomy: IS • Exogenous changes in the demand for goods & services. • Examples: • Housing boom or crash change in households’ wealth  C • Note that this implies a more complicated consumption function (see later) • change in business or consumer confidence or expectations  I and/or C • Expectations are not in the simple model (so far)

14. LM Shocks • Exogenous changes in the supply/demand for money. • Examples: • A wave of credit card fraud increases demand for money. • More ATMs or the Internet reduce money demand • Leaving the euro

15. LM1 r2 r1 IS2 IS1 Y1 Y2 Example: Irish Housing Mkt • Decline in house prices affects consumers wealth. • C falls (need more complicated C fn) • IS shifts left, causing • r and Y to fall. • Policy response? • Caveat: SOE r Y 15

16. Example: US recession of 2001 Causes: 1) Stock market decline  C Causes: 2) 9/11 • increased uncertainty • fall in consumer & business confidence • result: lower C & I Causes: 3) Corporate accounting scandals • Enron, WorldCom, etc. • reduced stock prices, discouraged investment

17. LM1 r2 r1 IS2 IS1 Y1 Y2 Example: US 2001 • Multiple reasons for decline in C & I • IS shifts left • Make sure you understand why? • Hint: this is a typical exam question. r Y 17

18. US Recession 2001 • The Policy Response • Fiscal policy: • tax cuts in 2001 and 2003 (T down) • spending increases (G up) • Shift IS curve to right (why?) • Monetary policy • Increase in M • shifted LM curve down (why?)

19. LM1 LM2 r IS1 IS2 Y Policy Response 2001 • Economy starts at A • Shock: IS1 IS2 • AB • FP: IS2 IS1 • MP: LM1LM2 • BC A B C

20. Great Depression • The biggest economic crash in modern times • Bigger than the crisis now • Policy makers learned a lot from great depression • Three questions • What was the cause? • What was the policy response? • What should have been the policy response?

21. Unemployment (right scale) Real GNP(left scale) The Great Depression 240 30 220 25 200 20 billions of 1958 dollars 180 15 percent of labor force 160 10 140 5 120 0 1929 1931 1933 1935 1937 1939

22. IS Shocks • Stock market crash  exogenous C • Oct 1929–Dec 1929: S&P 500 fell 17% • Oct 1929–Dec 1933: S&P 500 fell 71% • Drop in investment • Correction after overbuilding in the 1920s. • Widespread bank failures made it harder to obtain financing for investment. • Parallels with recent history • Contractionary fiscal policy • Politicians raised tax rates and cut spending to combat increasing deficits.

23. Monetary Shocks (LM) • Asserts that the Depression was largely due to huge fall in the money supply. • Milton Friedman: “Monetarist” Approach • Evidence: M fell 25% during 1929–33. • But, two problems with this hypothesis: • P fell even more, so M/Pactually rose slightly during 1929–31. • nominal interest rates fell, which is the opposite of what a leftward LMshift would cause.

24. The effects of falling prices • Strictly speaking ISLM not much use for analyzing deflation. • We will return to this later • The destabilizing effects of unexpected deflation:debt-deflation theory P (if unexpected)  transfers purchasing power from borrowers to lenders  borrowers spend less, lenders spend more  if borrowers’ propensity to spend is larger than lenders’, then aggregate spending falls, the IS curve shifts left, and Y falls

25. Another Depression is unlikely • Policymakers (or their advisers) now know much more about macroeconomics: • The Fed knows better than to let M fall so much, especially during a contraction. • Fiscal policymakers know better than to raise taxes or cut spending during a contraction. • Federal deposit insurance makes widespread bank failures very unlikely. • Automatic stabilizers make fiscal policy expansionary during an economic downturn.

26. The 2008–09 financial crisis & recession • 2009: Real GDP fell, u-rate approached 10% in US • Important factors in the crisis: • subprime mortgage crisis • bursting of house price bubble, rising foreclosure rates • falling stock prices • failing financial institutions • declining consumer confidence, drop in spending on consumer durables and investment goods

27. Change in U.S. house price index and rate of new foreclosures, 1999–2009

28. Consumer sentiment and growth in consumer durables and investment spending

29. The Policy Response • US • Tax cuts • Obama “Stimulus” • Fed “Quantitative Easing” • Combination makes situation better • Ireland • Tax rises • Cuts in expenditure • No change in money supply • Combination makes situation worse • Why do this?

30. The US • Start at A • The shock: • IS0 IS1 • AB • The stimulus: • IS1  IS2 • BC • Q easing: • LM0  LM0 • CD LM0 r A LM1 C B D IS0 IS2 IS1 y

31. Ireland • Start at A • The shock: • IS0 IS1 • AB • Austerity: • IS1  IS2 • BC LM0 r A B C D IS0 IS1 IS2 y

32. Conclusions • IS curve is equilibrium in the goods market • rIY • LM curve is equilibrium in Money market • YLr • Simultaneous equilibrium • Unique stable • Fiscal and Monetary policy • Crowding out • Quantitative easing • Shocks • examples

33. What’s Missing Three Big Things missing from the model • Expectations or forward looking behaviour • Hint of this in consumption out of wealth • No price adjustment • Very simplistic approach to supply side • Ignore openness of economy • Most countries are SOE