Goods%20

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Goods Financial Markets The IS-LM Model
The IS-LM Model
The determination of output and interest rates in
the short-run
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Goods Financial Markets The IS-LM Model
The goods market and the IS relation

• Equilibrium in the goods market Production (Y)
  Demand (Z)
• Or Investment Saving ? IS Relation
• Demand (Z) CIG CC(Y-T) T G are given
• Now let Investment depend on the level of sales
  (Y) and the interest rate (i)

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Goods Financial Markets The IS-LM Model
The IS curve
Equilibrium
In the goods market, the higher the interest
rate, the lower is investment and the lower is
equilibrium output.
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Goods Financial Markets The IS-LM Model
The IS curve
Shifts in the IS Curve
An increase in taxes shifts the IS curve to the
left
Interest Rate, i
Output, Y
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Goods Financial Markets The IS-LM Model
The IS curve
Shifts in the IS Curve
An increase in G shifts the IS curve to the right
Interest Rate, i
Output, Y
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Goods Financial Markets The IS Curve
Shifts in the IS curve
What do you think
How would a decrease in consumer confidence shift
the IS curve?
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Financial Markets and the LM Relation
Money market equilibrium Demand for liquidity
(L) Supply of Money (M)
M nominal money supply (controlled by the
Central Bank) YL(i) Demand for money
(function of nominal income and the interest
rate)
Equilibrium Interest Rate MYL(i)
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Financial Markets and the LM Relation
Real money, real income, and the interest rate
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Financial Markets and the LM Relation
An increase in demand for real balances
Increase in Y gt increases Md which increases i
Interest Rate, i
(Real) Money, M/P
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Financial Markets and the LM Relation
The LM curve
Interest Rate, i
Interest Rate, i
Income, Y
(Real) Money, M/P
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Financial Markets and the LM Relation
Shifts in the LM Curve Showing changes in M P
The LM curve
Interest Rate, i
LM (M/P)
Ms
LM (M/P gt M/P)
i
b
b
i
Interest Rate, i
i2
i2
a
i
a
i
Md (for Y gt Y)
i2
i2
Md (for Y)
M/P
M/P
Y
Y
Income, Y
(Real) Money, M/P
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The IS-LM Model Exercises
Equilibrium Requires
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The IS-LM Model Exercises
The IS-LM Equilibrium Graphically
LM
Interest Rate, i
IS
Y
Output, Y
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Fiscal Policy, Activity, and the Interest Rate
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Fiscal Policy, Activity, and the Interest Rate
The IS-LM Equilibrium Graphically

• IS LM Before the tax increase
• Equilibrium A i Y

LM

• IS After the tax increase

• Would the tax increase change
• LM?

• Disequilibrium at i (F, A) after
• tax increase

Interest Rate, i
A
F

• i, Y New equilibrium A

i
A

• The fiscal contraction lowered
• interest and output

i
IS (T)
IS (T gt T)
Y
Y
Output, Y
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Fiscal Policy, Activity, and the Interest Rate
Heres one for the devils advocate
Is deficit reduction good or bad for
investment? Interest rate falls ? good for
investment But Output falls ? bad for investment
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Monetary Policy, Activity, and the Interest Rate
Monetary Policy, Activity, and the Interest Rate
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Monetary Policy, Activity, and the Interest Rate
The IS-LM Equilibrium Graphically
LM (M/P)
LM (M/P gt M/P)

• IS LM Before increasing M
• Equilibrium A i Y

Interest Rate, i
B

• LM After increasing M

A
i

• Disequilibrium at i (A, B)

A
i

• New equilibrium A i Y

• Monetary expansion
• lowered i increased Y

IS
Y
Y
Output, Y
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Fiscal Policy and Monetary Policy Activity and
the Interest Rate
The effects of fiscal and monetary policy
Shift in IS Shift in LM Movement in Output Movement in Interest Rate
Increase in taxes left none down down
Decrease in taxes right none up up
Increase in spending right none up up
Decrease in spending left none down down
Increase in money none down up down
Decrease in money none up down up
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Using a Policy Mix
The Clinton-Greenspan Policy Mix
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Using a Policy Mix
The Clinton-Greenspan Policy Mix
LM
LM

• IS LM Before policy changes
• Equilibrium A i Y

Interest Rate, i

• IS After deficit reduced

A

• B equilibrium without monetary
• expansion

i
B

• LM after monetary expansion

A

• New equilibrium i, Y

i
IS
IS
Y
Y
Output, Y
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Using a Policy Mix
The Clinton-Greenspan Policy Mix
Observations

• Strong consumer confidence andstock market
  shifting IS from 1992to 1998
• The strong expansion automaticallyreduced the
  deficit (1 growth reducesthe deficit to GNP
  ratio by 0.5)

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Using a Policy Mix
The Clinton-Greenspan Policy Mix
The U.S. Economy 1991-1998
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Adding Dynamics
Observations

• Changes in output adjust slowly to changes in the
  goods market (IS)
• Interest rates adjust instantaneously to changes
  in the financial markets (LM)

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Adding Dynamics
Dynamics Graphically
Adjusting to a monetary contraction
Adjusting to a tax increase
LM
Interest Rate, i
Interest Rate, i
A
iA
iA
IS
A
Ya
Ya
Output, Y
Output, Y
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Adding Dynamics
The Dynamics of Monetary Contraction with IS-LM
LM
LM

• A Initial equilibrium (i Y)

A
i
Interest Rate, i

• LM After reducing money
• supply

A
i

• i rises to i

A

• Higher i reduces demand and
• output slowly A to A

i

• Equilibrium restored at A i, Y

IS
Y
Y
Output, Y
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Adding Dynamics
A Summary

• Monetary policy changes interest rates rapidly
  and output slowly
• The Central Bank must consider the output lag
  when implementing monetary policy

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Does the IS-LM Model Actually Capture What
Happens in the Economy?
The Empirical Effects of an Increase in the
FederalFunds Rate
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Does the IS-LM Model Actually Capture What
Happens in the Economy?
The Empirical Effects of an Increase in the
FederalFunds Rate
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Does the IS-LM Model Actually Capture What
Happens in the Economy?
The Empirical Effects of an Increase in the
FederalFunds Rate
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Does the IS-LM Model Actually Capture What
Happens in the Economy?
The Empirical Effects of an Increase in the
FederalFunds Rate
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Does the IS-LM Model Actually Capture What
Happens in the Economy?
The Empirical Effects of an Increase in the
FederalFunds Rate
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Does the IS-LM Model Actually Capture What
Happens in the Economy?
Summary
The IS-LM model is consistent with economic
observations The IS-LM model explains movements
in economic activity over the short-run