1. ISLM: The Engine Room Chapter 7

2. A curve in (i, Y) space comprising all points where the goods market is in equilibrium. Y = C + I + G Earlier, we defined : C = C + bI = I - fi Earlier, we defined : C = C + bY and I = I - fi Thus, Y = (C + b I – fi) + G Thus, Y = (C + bY) + ( I – fi) + G C + I + G, we have Let A = C + I + G, we have Y = b– fi Y = A + bY – fi fi = b fi = A – Y + bY Solving for i we get i = A/f i = A/f – Y(1 – b)/f A/f and slope equal to (This is an equation of a straight line with intercept equal to A/f and slope equal to – (1 – b)/f [Negative slope] The IS Curve

3. 1. IS curve response to a collapse in investor confidence (I). 2. IS curve response to a collapse in consumer confidence (C). 3. IS curve response to a change in government spending (G). Applications (fig. 7.2)

4. C = C – bY C T = C – bY D Y= Y(1 – t) Y D = Y(1 – t) C = C + bY(1 – t) C T = C + bY(1 – t) Using the equilibrium condition in the goods market Using the equilibrium condition in the goods market Y = C + I + G (with the after–tax C function) and solving for i we get Y = C T + I + G (with the after–tax C function) and solving for i we get i = A/f i = A/f – [1– b(1– t)]Y/f Now the slope is Now the slope is – [1– b(1– t)]/f (the IS curve becomes steeper; fig. 7.3) How do taxes affect the IS curve?

5. 1. The tax rate increases from 35% to 43%. 2. The tax rate increases in an economy struggling to recover from a prolonged recession (examples: tax increases in Japan in 1996, doubling of tax rates in the U.S. during the great depression, and state taxes in 1990-91.) Applications (fig. 7.4 and 7.5)

6. A curve in (i, Y) space comprising all points where the money market is in equilibrium. Money supply = Money demand Earlier (chapter 4), we defined: Money demand = kY – hi M/P = kY – hi Solving for i we get i = (k/h)Y i = (k/h)Y – (1/h)M/P (This is an equation of a straight line with intercept and slope equal to (k/h) equal to – (1/h)M/P and slope equal to (k/h) [positive slope] Fig. 7.6 The LM Curve

7. 1. A change in the nominal money stock, M. 2. A change in the price level, P. Factors that shift the LM curve (fig. 7.7)

8. Survival guide to ISLM-ADAS analysis  Make all moves in (i,Y) space first.  Go to (P,Y) space and adjust AD to make Y consistent with Y in the (i,Y) space.  Has P changed? If ‘no’, go to step 4. If ‘yes’, go to (i,Y) space and adjust LM.  Close the goods markets (and the labor market, to be incorporated in chapter 8). How do the final values of C and I compare with the initial values?  Analyze the implications of your results. ISLM – ADAS policy applications

9. Initial state of the economy: Low GDP growth rate Y 0. Assume government spending increases from G 0 to G 1 (spending on infrastructure, defense, …). Step 1: As G increases, the IS curve [(i,Y) space] shifts to the right (intercept increases). Step 2: In the (P,Y) space, the AD curve shifts to the right (upward). Step 3: P did not change we go to step 4. Step 4: The equilibrium in the goods market is consistent with Y 1 in the (i,Y) and (P,Y) spaces We know that C 1 > C 0 since Y 1 > Y 0 but what about investment, I? ISLM – ADAS policy experiment I (fig. 7.10)

10.  Recall that I = I - fi So I 0 = I - fi 0 But the new interest rate is higher as a result of higher government borrowing. So I 1 < I 0 Step 5: An increase in G causes an increase in the rate of growth of Y and a decrease in private capital investment (crowding out effect). Step 5: An increase in G causes an increase in the rate of growth of Y and a decrease in private capital investment (crowding out effect).

11. ISLM – ADAS policy experiment II The Fed increases money growth. Step 1: LM curve shifts to the right. Step 2: We adjust the AD curve in the (P,Y) space to ensure that Y is consistent with Y in the (i,Y) space. Step 3: P has not changed. Step 4: Shift (upward) the expenditure line in the goods market. Is C 1 > C 0 ? Yes (since Y 1 > Y 0 ). Is I 1 > I 0 ? Yes (since interest rate i 1 I 0 ? Yes (since interest rate i 1 < i 0 ). Step 5: An increase in money supply leads to a decrease in interest rate, and increase in investment, consumption, and Y.

12. ISLM – ADAS policy experiment III Country K has been struggling to come out of a recession and the budget deficit is very high. Policymakers decide to and the budget deficit is very high. Policymakers decide to increase taxes (T = tY). Step 1: IS curve pivots clockwise. C and I fall. Step 2: We adjust the AD curve in the (P,Y) space to ensure that Y is consistent with Y in the (i,Y) space. Step 3: P has not changed. Step 4: Shift (down) the expenditure line in the goods market. Is C 1 > C 0 ? No (since Y 1 C 0 ? No (since Y 1 < Y 0 ) and C is lower) Is I 1 > I 0 ? (i 1 I 0 ? (i 1 < i 0 but I 1 < I o (investor confidence is lower). If the macroeconomic outlook is dismal and investors expect further tax increases (investment) I will not rise (liquidity trap; U.S. economy in 2008; Japan and Argentina in early 2000s). Step 5: Y, C, I and interest rates (i) fall.

13. Policy Challenges in China  Bao ba (guaranteed 8%) growth policy  Low MPC (small multiplier)  IS curves for the Western and Central regions in China

14. ISLM – ADAS policy experiment IV: Fine tuning Country K increases G and M (to avoid crowding out private investment) Step 1: As G increases, IS curve shifts up (right). As M increases, LM curve shifts to the right. Step 2: We adjust the AD curve in the (P,Y) space to ensure that Y is consistent with Y in the (i,Y) space. Step 3: P has not changed. Step 4: We Adjust the expenditure line in the goods market to be consistent with Y 1. Is C 1 > C 0 ? Yes, since Y 1 > Y 0 Is I 1 > I 0 ? In this example, no change in the interest rate, i so I 1 = I o (assume investor confidence is the same). Step 5: Y and C increase.

15. The Global IS Curve Y = C + I + G + (EX – IM) i = [A/f + (EX – IM)/f] i = [A/f + (EX – IM)/f] – Y(1 – b)/f The intercept: A/f + (EX – IM)/f  An increase in exports causes the IS curve to shift upward (right).  A recession in a large foreign economy causes foreign national income to fall and causes foreign demand for domestic country’s exports to decline (contagion).  Effects of the home currency depreciation or devaluation (China and U.S.).