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NUIG Macro 1 Lecture 17: The IS/LM Model (1) Based Primarily on Mankiw Chapter 10

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2 Introduction & Learning Objectives u Today we will derive an IS curve and examine what determines the slope and position of the IS curve. – There are two ways to do this: using either the Keynesian cross model (traditional way), or using the neoclassical model (simpler). We will consider both derivations in turn. u In the next lecture we will derive an LM curve and examine what determines its slope and position. u After this, we will put the two curves together and present the complete IS/LM model. – This model is the basis for the claim made earlier that in the short-run both the goods market and the money market simultaneously determine r and Y.

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3 The Keynesian Cross (1) Planned Expenditure, E Income, Output Planned expenditure, E = C(Y-T*) + I* + G* a + I* + G* Actual Expenditure, Y=E 45 Y*Y* Using the Keynesian cross diagram we can see that the economy’s equilibrium income level is Y *. Whenever the economy is away from equilibrium, firms experience unplanned stock accumulation which acts as a signal for them to change production.

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4 The Keynesian Cross (2) u The Keynesian cross is useful because it shows how the spending plans of households, firms and the government determine the economy’s income. – We also noted in the last lecture how fiscal policy (changes in taxes and spending) can move the economy from a “bad” equilibrium (one with a low level of Y) to a good equilibrium (one with a level of Y closer to the natural rate of output). – In effect, the government can exploit the multiplier process and improve output and employment in the economy.

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5 Theoretical Weakness u Although the Keynesian cross is useful, it makes the simplifying assumption that the level of planned investment in the economy, I, is fixed at I*. This is unrealistic. – As we saw in earlier lectures, an important macroeconomic relationship is that planned investment depends on the real interest rate, r. – I = I(r) and it is assumed that whenever r rises then I falls. dI/dr < 0.

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6 Constructing The IS Curve u To determine how income changes when the interest rate changes, we can combine the investment function with the Keynesian cross diagram. – Because investment is inversely related to the interest rate, an increase in the interest rate from r 1 to r 2 reduces the quantity of investment from I(r 1 ) to I(r 2 ). – The reduction in planned investment, in turn, shifts the planned-expenditure function downward. The shift in the planned-expenditure function causes the level of income to fall from Y 1 to Y 2. – Hence, an increase in the interest rate lowers income. – The IS curve summarises the relationship between the interest rate and the level of income. – The IS curve is downward sloping in {r, Y} space.

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8 The Slope Of The IS Curve u The causality involved in constructing an IS curve is as follows – r changes I changes planned expenditure changes Y changes. – Thinking about this causality carefully, we can see that the slope of the IS curve will depend upon the interest elasticity of investment and the multiplier. – For any given value of the multiplier, an increase in the interest elasticity of investment will make the IS curve relatively flatter. – Similarly, if the interest elasticity of investment is held constant, a reduction in the multiplier will make the IS curve relatively steeper.

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9 Second Derivation u An simpler derivation comes from the neoclassical model. – Y = C + I + G – C = C(Y - T) – I = I(r) – G = G* – T = T* u Previously we would be assuming Y = Y* = F(K*, L*). u However, in the short-run (Keynesian model) Y is a variable. – Y = C(Y - T*) + I(r) + G* – I(r) = Y - C(Y - T*) - G*

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10 Second Derivation (continued) u RHS of equation is Y - C(Y - T*) - G* u As Y rises (by Y), the first term on the RHS gets larger as does the second term (C(Y - T*)). However, the second term only increases by MPC Y < Y. u Given that G is fixed the whole RHS increases in value when Y rises. u To preserve the equality the LHS must rise in value too. This means that I must rise. The only way this can happen is if r falls. u This is easy to see when we recall our basic equilibrium diagram from the neoclassical model and remove the restriction that Y is fixed at Y*. Again, IS is downward sloping in {r, Y} space.

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11 Fiscal Policy And The IS Curve u The IS curve is drawn under the assumption that fiscal policy is held constant. – When we draw the IS curve, G and T are held fixed. » The following slide uses the Keynesian cross to show how an increase in government spending from G 1 to G 2 shifts the IS curve. This figure is drawn for a given interest rate and thus for a given level of planned investment. The Keynesian cross shows that this change in fiscal policy raises planned expenditure and thereby increases equilibrium income from Y 1 to Y 2. » Therefore, an increase in government spending shifts the IS curve outward (to the right). The same is true of a tax cut. » Reduced government spending and increased taxes will shift the IS curve inward (to the left).

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13 Summary of IS Curve – The IS curve shows the combinations of r and Y that are consistent with equilibrium in the goods market. – The IS curve has a negative slope because reductions in r increase planned investment spending and thus, through the Keynesian cross, raise the level of income/output Y. – The multiplier and the interest elasticity of investment influence the slope of the IS curve. – Fiscal policy is one factor that influences the position of the IS curve.

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