Goods and Financial Markets Together: The IS-LM Model

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Goods andFinancial Markets TogetherThe IS-LM
Model
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The Goods Marketand the IS Relation

• Equilibrium in the goods market exists when
  production, Y, is equal to the demand for goods,
  Z.
• In the simple model (in chapter 3), the interest
  rate did not affect the demand for goods. The
  equilibrium condition was given by

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Investment, Sales (Y), and the Interest Rate (i)

• Now, we no longer assume I (investment) is
  constant
• We capture the effects of two factors affecting
  investment
• The level of sales/income ()
• The interest rate (-)

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The Determination of Output

• Taking into account the investment relation
  above, the equilibrium condition in the goods
  market becomes

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The Determination of Output
Equilibrium in the Goods Market
The demand for goods is an increasing function of
output. Equilibrium requires that the demand for
goods be equal to output.
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Deriving the IS Curve
The Effects of an Increase inthe Interest Rate
on Output

• An increase in the interest rate decreases the
  demand for goods at any level of output.

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The IS Curve
Shifts of the IS Curve

• An increase in taxes...

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Financial Marketsand the LM Relation

• The interest rate is determined by the equality
  of the supply of and the demand for money

M nominal money stockYL(i) demand for
moneyY nominal incomei nominal interest
rate
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Real Money, Real Income,and the Interest Rate

• The LM relation In equilibrium, the real money
  supply is equal to the real money demand, which
  depends on real income, Y, and the interest rate,
  i

Recall before, we had the same equation but in
nominal instead of real terms (nominal income and
nominal money supply). Dividing both sides by P
(the price level) gives us the equation above.
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Deriving the LM Curve
The Effects of an Increase in Income on the
Interest Rate
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Shifts of the LM Curve
Shifts of the LM Curve

• An increase in money...

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The IS and the LM Relations Together
The IS-LM Model

• Equilibrium in the goods market (IS).
• Equilibrium in financial markets (LM).
• When the IS curve intersects the LM curve, both
  goods and financial markets are in equilibrium.

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Fiscal Policy, the Interest Rate and the IS Curve

• Fiscal contraction a fiscal policy that reduces
  the budget deficit.
• Reducing G or increasing T
• Fiscal expansion increasing the budget deficit.
• Increasing G or decreasing T
• Taxes (T) and government expenditures (G) affect
  the IS curve, not the LM curve.

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Fiscal Policy, the Interest Rate and the IS Curve
The Effects of an Increase in Taxes
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Monetary Policy, the Interest Rate, and the LM
Curve

• Monetary contraction (tightening) refers to a
  decrease in the money supply.
• An increase in the money supply is called
  monetary expansion.
• Monetary policy affects only the LM curve, not
  the IS curve.

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Monetary Policy, the Interest Rate, and the LM
Curve
The Effects of a Monetary Expansion
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Recent U.S. Monetary Policy
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Using a Policy Mix
The Effects of Fiscal and Monetary Policy. The Effects of Fiscal and Monetary Policy. The Effects of Fiscal and Monetary Policy. The Effects of Fiscal and Monetary Policy.
Shift of IS Shift of LM Movement of 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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German Unification and the German Monetary-Fiscal
Policy Mix
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U.S. Money Supply during the Great Depression
(1928-1936)
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U.S. Fiscal Policy during the Great Depression
(1930-1947)
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The U.S. Recession of 2001
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Mr. Greenspan