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IS-LM Revisited

IS-LM Revisited. Simple Income Determination Properties of IS & LM Curves Equilibrium Output & Interest Rates Economic Policy. (1) Simple Income Determination * Eco 1002 * Goods Market (IS) * Exogenous Interest Rate & Prices * Endogenous Income (GDP) (2) IS-LM Model

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IS-LM Revisited

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  1. IS-LM Revisited Simple Income Determination Properties of IS & LM Curves Equilibrium Output & Interest Rates Economic Policy

  2. (1) Simple Income Determination * Eco 1002 * Goods Market (IS) * Exogenous Interest Rate & Prices * Endogenous Income (GDP) (2) IS-LM Model * Eco 2101 (Keynesian Short-Run) * (1) + Money Market * Endogenous Income & Interest Rate (Fixed P) • Endogenous Policy

  3. Simple Income Determination(Eco 1001) • Behavioral Assumptions: Consumption = C (y, r) y = disposable income = Y – T r = interest rate MPC = where 0 < Cy < 1 Investment = I(r) Government Purchases = G • Exogenous: r, P, Fiscal Policy: G, T • Endogenous: Y • Linear Examples

  4. Equilibrium: • Some Basic Results: (interest rates and GDP) (Gov. Spending Multiplier) (Tax Multiplier)

  5. IS-LM Model (Eco 2101) • Goods & Money Market Equilibrium • IS-LM Model Exogenous: P, Fiscal Policy: G, T Monetary Policy: Ms Endogenous: Y and r

  6. IS and the Goods Market • Goods Market Equilibrium: Y = C(y,r) + I(r) + G (IS equation) where y = Y – T = disposable income 0< Cy < 1 Ir < 0 G and T are exogenous policy variables

  7. Properties of IS curve: Slope*: Government spending multiplier: (shifts right) Tax Multiplier: (shifts left)

  8. LM and the Money Market • Real Money Demand = L(Y,r) • Money Market Equilibrium: Ms = P*L(Y,r) (LM equation) Ms is an exogenous policy variable.

  9. Properties of LM curve Slope*: Real Money Supply: (shifts right)

  10. The Simple IS-LM Model - (Y,r) which solves: (IS) (LM)

  11. Policy in IS-LM Model Exogenous: P Endogenous: Y, r Policy Variables: G, Ms, T • Fiscal Policy (1) Government Expenditures (dG) but less than 1/(1-Cy)!

  12. Crowding-out effect! • Effectiveness of G: If (IS Flat) or (LM verticle) then . (Complete crowding-out!) (2) Taxes (dT): dY/dT = ?, dr/dT = ?

  13. Monetary Policy (dMs):

  14. Effectiveness of monetary policy: If (IS vertical) or (LM flat) Then (Ineffective Monetary Policy)

  15. Liquidity Trap and Interest Rate Insensitivity • Great Depression YearURipr = i - p 1930 8.9 3.6 -2.6 6.2 1931 16.3 2.6 -10.1 12.7 1932 24.1 2.7 -9.3 12.0 1933 25.2 1.7 -2.2 3.4 1934 22.0 1.0 7.4 -6.6 1935 20.3 0.8 0.9 -0.1 1936 17.0 0.8 0.2 0.6

  16. 2008-09 Recession Jan 2007 – Jan 2010, Federal funds rate cut from 6% to 1%. i UR Jan 2007 5.25% 4.6% Jan 2008 3.94% 5% Jan 2009 0.15% 7.7% Jan 2010 0.12% 10%

  17. Business Cycles in IS-LM • Shocks to Consumer confidence (g): C = C(Y,r,g) where Cg > 0  dY*/dg > 0 dr*/dg > 0 • Shocks to money demand (s): L = L(y,r,s) where Ls> 0  dY*/ds < 0 dr*/ds > 0

  18. Endogenous Policy • Monetary/Fiscal Policy responds to economic conditions to achieve goal. Objective: dY = 0 (output stability) OR dr = 0 (interest rate stability) Exogenous: Policies - Ms or G, or T Shocks – g or s Endogenous: Policies - Ms or G, or T

  19. Example: An increase in G and Fed’s objective is to keep r constant (prevent crowding out). • Step 1: Set dr = 0 Step 2: Treat dY and dMs as endogenous, dG as exogenous. Step 3: Use Cramer’s Rule to solve for dY/dG and dMs/dG. Suppose instead Fed wanted to keep output stable (dY = 0). Find dr/dG and dMs/dG.

  20. Evaluation of Simple Keynesian IS-LM Models • Provided reasonable explanation of business cycles. • Guides policymakers on stabilizing economic fluctuations. • Can be applied easily to think about current events.

  21. Shortcomings • Criticisms of IS-LM Model: (1) Emphasis on aggregate demand. (2) Static Model. (3) Lack of solid microeconomic foundations. • Lucas Critique on Policy Evaluation • Examples: Consumption, Phillips Curve

  22. Modern Macro • Dynamics • Expectations (rational) • Microeconomic Foundations Most modern macro models (New Classical and New Keynesian) have these features.

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