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Chapter 5 The IS-LM Model: Framework for Macroeconomic Analysis

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Chapter 2. Introduction This chapter integrates the elements of our model covering labor, goods, and asset markets. It develops a graphical depiction of our theory that is called the IS-LM/AD-AS model. –IS and LM refer to two equilibrium conditions in the model (investment equals saving; money demand, or liquidity preference, equals money supply). –AD and AS refer to aggregate demand and aggregate supply.

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The IS-LM model The IS-LM model translates the General Theory of Keynes into neoclassical terms (often called the neoclassic synthesis ) It was proposed by John Hicks in 1937 in a paper called Mr Keynes and the "Classics": A Suggested Interpretation and enhanced by Alvin Hansen (hence it is also called the Hicks- Hansen model). The model examines the combined equilibrium of two markets : –The goods market, which is at equilibrium when investments equal savings, hence IS. –The money market, which is at equilibrium when the demand for liquidity equals money supply, hence LM. –Examining the joint equilibrium in these two markets allows us to determine two variables : output Y and the interest rate i.

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The IS-LM model The model rests on two fundamental assumptions –All prices (including wages) are fixed. –There exists excess production capacity in the economy This is a complete change in perspective compared to classical economics: –The level of demand determines the level of output and employment. –There can be an equilibrium level of involuntary unemployment. Why can there be insufficient demand ? –Criticism of Says law: Uncertainty can lead to precautionary saving rather than consumption. –Monetary criticism: the preference for liquidity can lead to under- investment as savings are kept in the form of liquidity.

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The IS-LM model The IS-LM model has become the standard model in macroeconomics. Its essential contribution (linked to that of Keynes) is this potential equilibrium unemployment: –Such a situation is impossible in earlier neoclassic models, as the price of labour (like all prices) is assumed to adjust naturally until supply and demand for labour are balanced. This is why IS-LM (1937!!) remains central to modern macroeconomics, and has been extended to explain more markets/ variables: –The AS-AD model adds inflation into the problem –The Mundell-Fleming model deals with international trade

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Deriving the IS Curve Recall the Goods Market Equilibrium Condition:

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Goods Market Equilibrium r S d, I d I S

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Goods Market Equilibrium r S d, I d I S r S d = I d

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Consider a Rise in Income As income rises, the desired saving curve shifts right, and the equilibrium rate of interest falls as we slide down the desired investment curve (next slide).

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Goods Market Equilibrium r S d, I d I S r0r0 S d = I d

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Goods Market Equilibrium r S d, I d I S r1r1 S d = I d S (Higher Income) r0r0

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Deriving IS The previous slide shows that as income varies and goods market equilibrium is maintained, a higher value of income is associated with a lower value of the expected real interest rate Plot the income-interest rate pairs that satisfy the goods market equilibrium condition to get the IS curve –NOTE : Each Saving curve slopes upward because an increase in the real interest rate causes house hold to increase there desire level of savings. –NOTE :An investment curve slopes downward because an increase in interest rate increases the uses cost of capital which reduces the desired capital stock and hence desired investment. –The inverse relationship between income and interest rate implies that the IS curve is downward sloping

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Figure 9.2 Deriving the IS curve

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Shifting IS For constant Output, Any changes in the economy that reduces the desired national saving relative to desired investment will increase the interest rate that clears the good market thus shifting the IS curve up and to the right. Similarly for constant output, Any changes in the economy that that increases the desired national saving relative to desire investment will reduce the market interest rate shifting the IS curve down and to the left.

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Shifting IS Recall that IS was derived by considering how the desired saving curve moved along the desired investment curve as income changed. Suppose a shock (say a government spending increase) causes saving to decline at each level of income –Then the interest rate is higher at each level of income. –Then we must redraw IS, with higher r for each level of Y. IS has shifted to the right. For other shocks that shift saving or investment schedules, we can also infer how IS shifts.

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Effects on IS curve with increase in Government Purchases

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IS Curve Shifters Variable IncreasesIS Curve Shifts Expected Future Output (Income) Right (desired saving falls, desired consumption rises WealthRight ( same as above) Government SpendingRight (direct effect on savings) TaxesNone (Ricardian) or Left Expected future MPKRight Effective Tax Rate on KLeft

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The LM Curve The IS plots income interest-rate pairs such that desired spending is equal to output, or desired saving is equal to desired investment We will now derive the LM curve, which plots income-interest rate pairs such that the quantity of money demanded is equal to the quantity of money supplied.

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Money Market Equilibrium Revisited

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The LM Curve

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The Derivation of LM

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Factors that shifts LM curve Changes In the real money supply Ms For constant output, any changes that reduces the real money supply relative to real money demanded will increase the real interest rate and causes the LM curve to shift up and to the left. Similarly, for constant output anything that raises the real money supply relative to real money demand will reduce the real interest rate that clears the market and shifts the LM curve down to the to the right.

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Factors that shift the LM curve changes in the real money demanded Md With output constant, an increase in real money demanded raises the real interest rate and thus shift the LM curve up and to the left. Analogously, with output constant, a drop in real money demanded reduces the interest rate and shift the LM curve down to the right.

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LM Curve Shifters Variable IncreasesLM Curve Shifts Nominal Money Supply Right( Real money supply increases lowering real int rates equates Ms = Md ) Price LevelLeft ( real money supply falls raising real int rates that clears the asset market ) Expected InflationRight ( Demand for money falls lowering the real int rates that clears the asset market ) Nominal interest rate on money i m Left ( demand for money increases, higher return on money makes people willing to hold more money, raising the real interest rates that clears the asset market ) Anything Else Increasing the Demand for Money Left

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General Equilibrium in the IS- LM Model In general equilibrium, all markets satisfy their respective equilibrium conditions. –Labor, Goods, and Money Markets Must all be in equilibrium. The logic of general equilibrium: –The labor market determines output. –Given output (income) the goods market then determines an interest rate. –Given output, the interest rate, and the expected inflation rate, then the money market determines the price level.

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General Equilibrium in the IS- LM Model (Diagram)

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Equilibrium: A Coincidence? Labor Market equilibrium requires that the economy be on the FE line Goods Market equilibrium requires that the economy be on the IS Curve Money Market equilibrium requires that the economy be on the LM Curve General equilibrium requires that the economy be on all three curves simultaneously Does this require a happy coincidence? (No)

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Review on Equilibrium To review, output is determined by the FE line Given output the intersection of IS and FE determines the interest rate Finally, the price level adjusts so that LM intersects both IS and FE

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Timing of Movement to Equilibrium Our model, as formulated, does not tell us the order in which variables movewe just infer that the economy moves from one equilibrium to another (after a shock). Here are some thoughts on timing: –Interest rates (and financial markets generally) adjust very quickly –Nominal (and real) wages adjust slowly (often wages are set for long periods of time –Prices may also adjust slowly –The goods market adjusts with intermediate speed (we often see unanticipated inventory movements, but firms may alter production before revising prices)

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A Look Ahead: Keynesian and Classical Views We will say much more about Keynesian and Classical macroeconomic theories Keynesians emphasize the short-term rigidity of prices and wages Classical economists emphasize that all markets reach equilibria rather quickly

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Aggregate Demand and Aggregate Supply We have now specified a complete model However, sometimes it is convenient to look at the model differentlywith a different diagram We next introduce AD and AS curves –These curves plot output, Y, and the price level, P. –These diagrams allow us to focus attention on the determination of the price level, which was not directly visible in the IS-LM diagram.

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