MGE 6'1

1

• Session 6 Stock, Bonds, Investment and Economic
  Activity
• putting it all together
• Goal To develop a tool to see the short-term
  effects of different events on output and
  interest rates.
• Goods/Financial market IS curve
• Money market LM curve
• IS-LM interest rate clearing both markets
• Effects of Fiscal and Monetary policies

Loïc Sadoulet Macroeconomics in a Global
Economy P3 Jan-Feb. 2004
2
So far we have seen

• Goods market / Loanable funds (stock) Market
• Y C I G
• How is interest rate determined? I S
• Money market
• Money demand affected by
• Income, velocity shifts the money demand curve
• Returns on alternative assets (opportunity cost)
  mvt. along the curve
• Money supply affected by
• Central bank policy private sector behavior
  (multiplier)
• Interest rate is determined by Money supply
  Money demand

3
I. The IS Curve (Goods / loanable funds market)

• Recall equilibrium in goods market
• Total output Total expenditure Y C I G
  NX
• Use of savings identity (in closed economy) S
  I
• Interest rates adjust to make identity hold
• Session 2 effect of income on savings?
• Session 3 effect of savings on interest rates?

4
Session 2 Effect of income on Savings
5
Session 3 Savings and interest rates
6
IS Curve relationship between Y and r(in
goods/loanable funds market)
Real r
Real r
S(low Y)
S(high Y)
high r
high r
low r
low r
IS
I
output
high Y
Investment/ Savings
low Y
IS investment savings
7
Shifting the IS Curve(at given income)
e.g. increase in G
1. An increase in government spending reduces
aggregate savings(at any given interest rate)
2. which leads to an increase in interest rates
for any level of Y
Real r
Real r
S (high G)
S (low G)
DG
r (high G)
IS (high G)
r (low G)
r (low G)
r (low G)
IS
I
output
Y
Investment/ Savings
8
Shifting the IS Curve(at given income)
e.g. increase in mpc
1. An increase in mpc reduces aggregate
savings(at any given r)
2. which leads to an increase in interest rates
for any level of Y
Real r
Real r
S (high mpc)
S (low mpc)
DC
r (high mpc)
IS (high mpc)
r (low mpc)
r (low mpc)
IS
I
output
Y
Investment/ Savings
9
Shifting the IS Curve(at given income)
e.g. increase in productivity
1. An increase in productivity increases desired
investment (at any given r)
2. which leads to an increase in interest rates
for any level of Y
Real r
Real r
S
r (high prod)
IS (high prod)
DI
r (low prod)
IS
I
output
Y
Investment/ Savings
10
Events shifting the IS curve

• Anything that affects savings for a given level
  of income
• Fiscal policy (T, G)
• Changes in consumption patterns (at given income)
• Anything that affects investment behavior of
  firms
• Expected profitability of investments
• Expectations

11
CAREFUL When Shifting IS curve, Keep Income
Fixed!!
12
II. The LM Curve(the money market)

• Interest rate in the money market is determined
  by money demand and money supply
• Session 3 - Effect of income on money supply?
• - Effect of income on money demand?
• - Effect of income on interest rates?

13
II. The LM Curve(the money market)
14
LM Curve relationship between Y and r(in money
market)
15
Shifting the LM Curve(at given income)
e.g. decrease in money supply
16
Shifting the LM Curve(at given income)
e.g. decrease in money supply
17
Events shifting the LM curve

• Anything that shifts the supply of real balances
  for a given level of income
• Monetary policy, affecting the nominal money
  stock M
• An increase in the price level P, reducing the
  real money stock M/P
• Anything that shifts the demand for real balances
  for a given level of income
• An increase in wealth / confidence
• An increase in the liquidity of other assets
• An increase in the efficiency of payment
  technologies

18
CAREFUL When Shifting LM curve, Keep Income
Fixed!!
19
All of it together
20
Why would interest rates be equal?
What if they were different?
21
Why would interest rates be equal?
(1) Take savings out of stock market (increasing
interest rate in the loanable funds market)
(3) Note that Y falls due to lower investment
( GDP multiplier effect)
(2) and put that money in a savings account (or
government bonds), reducing money demand (and
thus reducing interest rates on money)
22
As a summary on interest rates

• If higher in money market
• Buy bonds instead of lending funds to firms for
  investment
• Decrease in supply of funds in loanable funds
  market
• If higher in loanable funds market
• Do not saving in bonds
• Increase money demand to lend cash to firms
  directly

How do we know that both interest rates in the
money market and in the loanable funds market
will end up being the same?
Interest rates are the same, up to risk premia!
23
Strategy for IS-LM

• Snap shot interest rates
• Look at exogenous changes (i.e. not due to income
  changes)
• in Money supply
• in Money demand
• in Investment demand
• in Savings
• Examine initial impact in market for loanable
  funds or money market without taking into
  account the impact on income!
• Final impact on income includes the Aggregate
  Demand (GDP) Multiplier effect

24
Expansionary Monetary Policy
Initial Point
25
Expansionary Monetary Policy
(1) an increase in money supply leads to a fall
in interest rates in bond market
26
Expansionary Monetary Policy
(shift down the LM Curve)
27
Expansionary Monetary Policy
(2) Lower interest rates in bond market than in
stock market leads to arbitrage
28
Expansionary Monetary Policy
(3) The flow of funds to the stock market lowers
the interest rate on loanable funds which
stimulates more investment
29
Expansionary Monetary Policy
(4) Higher investment leads to higher output
(with multiplier effect)
30
Expansionary Monetary Policy

• Increase in money supply leads to a decrease in
  interest rates (LM shifts down)
• Lower interest rates in bond market leads to
  arbitrage
• Which leads to higher investment
• Which stimulates higher output

31
Expansionary Fiscal Policy
An exogenous increase in government spending
32
Expansionary Fiscal Policy
Snew
r
(1) leads to a fall in Aggregate Savings and
raises interest rates on stock market
DG
Notice the crowding out of private investment
33
Expansionary Fiscal Policy
Snew
r
(shift IS up)
r
ISnew
34
Expansionary Fiscal Policy
Snew
(2) Lower interest rates in bond market than in
stock market leads to arbitrage
r2
r
r2
ISnew
35
Expansionary Fiscal Policy
Snew
r2
(3) The flow of funds to the stock market lowers
the interest rate on loanable funds which
stimulates investment a bit
DI
Inew
r
r2
ISnew
36
Expansionary Fiscal Policy
Snew
(4) All this leads to higher output
r2
Inew
r2
ISnew
Ynew
37
Expansionary Fiscal Policy
Snew
Why Higher Output?
r2

• I has fallen (crowding out)
• but aggregate demand multiplier effect

Inew
r2
ISnew
Ynew
38
Expansionary Fiscal Policy

• Decreased savings which led to an increase in
  interest rates at given Y (IS shifts up)
• Higher returns on stock market leads to arbitrage
• Higher government spending crowded out private
  investment, but increased Y due to aggregate
  demand multiplier effect.

39
Summary Session 6

• ISLM looks at the simultaneous equilibrium in the
  money and the goods/loanable funds market
• Useful tool to analyze policy changes or effects
  of exogenous shocks
• Important properties
• IS and LM only shift when the change in behavior
  is due to something else than income
• Any reaction to a change in income is a movement
  along the IS and LM curves

40
ISLM and Current Issues

• Stimulation out of a recession Monetary or
  Fiscal Policy
• Crowding out and long-term growth
• Over-investment bubbles
• Flight to quality and credit crunch