The ISLMFE Model

1
The IS-LM-FE Model

• FE line
• IS and LM Curves
• Short and Long Run Equilibrium

2

• The IS-LM Model provides a framework which
• (1) Combines our three markets into one
  diagram.
• (2) Allows simultaneous determination of (Y,r,
  P)
• (3) Distinguishes between short-run and
  long-run equilibrium.
• (4) Provides a unifying framework for studying
  business cycle theories.

3
Labor Market Equilibrium (FE)

• Labor Market Equilibrium
• The FE line is vertical at the full employment
  level of output.
• Any factors which changes will shift the FE
  line Supply shocks (DA), shifts in NS curve.

4
Good Market Equilibrium IS-Curve

• Good Market Equilibrium
• Question How are Y and equilibrium r related in
  the good market?
• The IS curve shows combinations of (Y,r) which
  keeps the goods market in equilibrium
• Downward sloping gt Dr move along IS curve

5

• Any point above IS Curve (point x)
• S gt Id
• Iu gt 0
• Y gt C Id G
• Any point below IS Curve (point x)
• S lt Id
• Iu lt 0
• Y lt C Id G

6

• All points along IS Curve
• S Id
• Iu 0
• Y C Id G

7

• Any factor other than Y which changes
  equilibrium r in the goods market will shift the
  IS curve.
• An increase in
• (1) Wealth/Consumer Confidence
• gt S curve left and IS right
• (2) Income Taxes (T)
• gt S shifts right and IS left

8

• (3) Government Purchases (G)
• gt S curve left and IS right
• (4) MPKf
• gt Id curve right and IS right
• (5) Corporate taxes
• gt Id curve left and IS left
• Convenient rule-of-thumb Factors (other than Y
  and r) which increases aggregate demand (C, Id,
  G) will shift IS curve right.

9
Money Market EquilibriumLM Curve

• Money Market Equilibrium
• Question How are Y and r related in the money
  market for a given price level P?
• The LM curve shows combinations of (Y,r) which
  keeps the money market in equilibrium
• Upward sloping gt Dr move along LM curve

10

• Any point above LM (point x) MD lt MS
• Any point below LM (point x) MD gt MS
• All points along LM MD MS
• Any factor other than Y which changes
  equilibrium r in the money market will shift the
  LM curve.
• An increase in
• (1) Nominal Money Supply (Ms)
• gt shifts MS and LM right

11

• The Price Level (P)
• gt shifts MS and LM left
• Expected Inflation (pe)
• gt shifts MD left and LM right
• Other MD Factors (financial market risk, payments
  system)
• MD right gt LM left

12

• A long-run or full employment equilibrium occurs
  when the following markets are in equilibrium
• (1) labor market (FE)
• (2) goods market (IS)
• (3) money market (LM)
• Textbook calls this a General Equilibrium.
• The long-run equilibrium determines three
  important aggregate variables
• Sometimes called a flexible price (Classical)
  equilibrium.

13

• The price level adjusts to ensure economy
  maintains GDP at full employment level.
• The long-run in IS-LM-FE model is identical to
  the results from our full employment economy.

14

• Example Temporary Negative Supply Shock.
• A short-run equilibrium occurs when the following
  markets are in equilibrium
• (1) goods market (IS)
• (2) money market (LM)
• The short-run equilibrium (given fixed P)
  determines Y and r
• Sometime called a fixed price (Keynesian)
  equilibrium.

15
Steps to Analyzing IS-LM Model

• Identify which market/curve shifts which
  direction.
• Short Run ? (Y,r) where IS-LM intersect
• Long-Run/Full Employment ? (Y,r) where FE and IS
  intersect.
• Which direction must LM shift for IS-LM-FE to
  intersect at point in Step 3.
• Step 4 ? how P much change.

16
Terminology

• Full Employment Equilibrium is also called a
• Long-Run Equilibrium
• Flexible Price (Classical) Equilibrium
• General Equilibrium (Textbook)
• A Short-Run Equilibrium is identical to a
• Fixed Price (Keynesian) Equiibrium

17

• Example Consumer Confidence
• Example Confidence in Financial Markets
• Example Fiscal and Monetary Policy
• Wars and the Economy
• Monetary Policy Interest Rates
• Fiscal Monetary Policy Mix
• (accommodative, neutral, extinguishing)

18
The Growth Rate of U.S. Real Gross Domestic
Product since 1870
19
Money and Interest Rates
20
Monetary Policy 2004 - 2008
21
FOMC Statement 6/29/06

• The Federal Open Market Committee decided today
  to raise its target for the federal funds rate by
  25 basis points to 5-1/4 percent.
• Recent indicators suggest that economic growth is
  moderating from its quite strong pace earlier
  this year
• Readings on core inflation have been elevated in
  recent months the Committee judges that some
  inflation risks remain. In any event, the
  Committee will respond to changes in economic
  prospects as needed to support the attainment of
  its objectives.

22
FOMC Statement 3/18/2008

• The Federal Open Market Committee decided today
  to lower its target for the federal funds rate 75
  basis points to 2-1/4 percent.
• Recent information indicates that the outlook for
  economic activity has weakened further
  Financial markets remain under considerable
  stress Inflation has been elevated, and some
  indicators of inflation expectations have risen. 
  Uncertainty about the inflation outlook has
  increased.
• Downside risks to growth remain.  The Committee
  will act in a timely manner as needed to promote
  sustainable economic growth and price stability.

23
Practice IS-LM Problems

• Textbook, Chapter 9
• Analytical Problems 1, 2 (p 349)
• Analytical Problem 3 (p 350)
• Next Tuesday I will call on volunteers to do
  these in class (for extra credit!)