1. Goods & Financial Markets: The IS-LM Model
The determination of output and
interest rates in the short-run

2. 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)= C+I+G C=C(Y-T) T & G are given
Now let Investment depend on the level of sales (Y) and the interest rate (i):

3. Goods & Financial Markets: The IS-LM Model
The IS curve
Equilibrium:
Supply of
Goods
Demand for
Goods (Z)
In the goods market, the higher the interest rate, the lower is investment and the lower is equilibrium output.

4. Goods & Financial Markets: The IS-LM Model
The IS curve
Shifts in the IS Curve:
IS´ (T´ > T) Y´
IS (T)
An increase in taxes shifts the IS curve to the left
Interest Rate, i i Y
Output, Y

5. Goods & Financial Markets: The IS-LM Model
The IS curve
Shifts in the IS Curve:
IS (G) Y i Y´
IS´ (G´ > G)
An increase in G shifts the IS curve to the right
Interest Rate, i
Output, Y

6. 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?

7. 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)
$YL(i) = Demand for money (function of nominal income and the interest rate)
Equilibrium Interest Rate:
M=$YL(i)

8. Financial Markets and the LM Relation
Real money, real income, and the interest rate
Real Income
Real Money Supply =Real Money Demand: Y(L)i
LM relation:

9. Financial Markets and the LM Relation
An increase in demand for real balances:
M/P A i Ms A´ i´
Md´ (for Y´ > Y)
Md (for Y)
Increase in Y => increases Md which increases i
Interest Rate, i
(Real) Money, M/P

10. Financial Markets and the LM Relation
The LM curve
Interest Rate, i
M/P Ms
LM (M/P) A´
Md´ (for Y´ > Y)
Md (for Y) i´ A´ Y´
Interest Rate, i A Y i
(Real) Money, M/P
Income, Y

11. Financial Markets and the LM Relation
The LM curve
Shifts in the LM Curve:
Showing changes in M & P Ms
Ms´ a´ b´
Interest Rate, i
LM (M/P)
LM´
(M´/P > M/P) b i´ i´ b
Interest Rate, i
i´2
i´2 a b´ i i a
Md´ (for Y´ > Y) i2 i2 a´
Md (for Y)
M/P
M´/P Y Y´
(Real) Money, M/P
Income, Y

12. The IS-LM Model Exercises
Equilibrium Requires:

13. The IS-LM Model Exercises
The IS-LM Equilibrium Graphically LM
Interest Rate, i
i & Y is the only interest rate, output combination that yields a simultaneous equilibrium in the goods and financial markets i IS Y
Output, Y

14. Fiscal Policy, Activity, and the Interest Rate
A Scenario:
The President and Congress agree on a policy to reduce the budget deficit by increasing taxes, while holding gov’t spending constant.
Question:
What impact will this fiscal contraction policy have on output and interest rates?
What shifts? IS, LM or both?
ANSWER: IS

15. 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?
Interest Rate, i
Disequilibrium at i (F, A) after
tax increase F A
i´, Y´ New equilibrium A´ i A´
The fiscal contraction lowered
interest and output i´
IS (T)
IS´ (T´ > T) Y´ Y
Output, Y

16. Fiscal Policy, Activity, and the Interest Rate
Here’s one for the devil’s advocate…
Is deficit reduction good or bad for investment?
Interest rate falls  good for investment
But
Output falls  bad for investment

17. Monetary Policy, Activity, and the Interest Rate
A Scenario:
The Fed engages in monetary expansion, i.e., it increases the money supply through open market operations
Question:
What impact will the monetary expansion have on output and interest?
What shifts? IS, LM, or both?
ANSWER: LM

18. Monetary Policy, Activity, and the Interest Rate
The IS-LM Equilibrium Graphically
LM (M/P)
LM´ (M´/P > M/P)
IS & LM: Before increasing M
Equilibrium A: i & Y
Interest Rate, i A B
LM´: After increasing M i
Disequilibrium at i (A, B) A´ i´
New equilibrium A´: i´ & Y´
Monetary expansion
lowered i & increased Y IS Y Y´
Output, Y

19. 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
Decrease in taxes
right up
Increase in spending
Decrease in spending
Increase in money
Decrease in money

20. Using a Policy Mix The policy dilemma of 1992:
The Clinton-Greenspan Policy Mix
The policy dilemma of 1992:
Record high federal budget deficit (4.5% of GNP)
High unemployment and slow growth
Recall:
Deficit reduction reduces output
Expansionary fiscal policy increases the deficit
Solution: Policy Mix
Deficit reduction and expansionary monetary policy

21. Using a Policy Mix The Clinton-Greenspan Policy Mix Interest Rate, iLM
LM´
IS & LM: Before policy changes
Equilibrium A: i & Y
Interest Rate, i
IS´: After deficit reduced A i
B equilibrium without monetary
expansion B
LM´ after monetary expansion A´ i´
New equilibrium i´, Y´ IS
IS´ Y Y´
Output, Y

22. Using a Policy Mix
The Clinton-Greenspan Policy Mix
Observations:
Strong consumer confidence and stock market shifting IS from 1992 to 1998
The strong expansion automatically reduced the deficit (1% growth reduces the deficit to GNP ratio by 0.5%)

23. Using a Policy Mix The Clinton-Greenspan Policy Mix
The U.S. Economy
Budget surplus
(% of GDP)
(minus sign:
deficit)
GDP growth (%)
Interest rate (%)

24. 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)

25. Adding Dynamics Dynamics Graphically LM´ LM IS´ B Interest Rate, i
Adjusting to a
tax increase
Adjusting to a
monetary contraction LM
IS´ B
Interest Rate, i
Interest Rate, i
Output
decreases
slowly iB B A´ iA Yb
Interest rates
adjust
instantaneously IS iA A Ya Ya
Output, Y
Output, Y

26. Adding Dynamics The Dynamics of Monetary Contraction with IS-LM
A: Initial equilibrium (i & Y)
A´´
Interest Rate, i
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

27. 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

28. Does the IS-LM Model Actually Capture What Happens in the Economy?
The Empirical Effects of an Increase in the Federal Funds Rate

29. Does the IS-LM Model Actually Capture What Happens in the Economy?
The Empirical Effects of an Increase in the Federal Funds Rate

30. Does the IS-LM Model Actually Capture What Happens in the Economy?
The Empirical Effects of an Increase in the Federal Funds Rate

31. Does the IS-LM Model Actually Capture What Happens in the Economy?
The Empirical Effects of an Increase in the Federal Funds Rate

32. Does the IS-LM Model Actually Capture What Happens in the Economy?
The Empirical Effects of an Increase in the Federal Funds Rate

33. 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