Goods and Financial Markets: The IS-LM Model In this chapter we will look at the; 1. Goods market and derive the IS relation. 2. Financial markets and derive the LM relation. 3. We will learn how output and the interest rate are determined in IS-LM framework in the short run.

The Goods Market and the IS Relation Equilibrium in the goods market exists when production, Y, is equal to the demand for goods, Z. We took I, G and T as given (exogenous). And the equilibrium condition was given by: Y = C(Y − T) + I + G In the simple model developed in chapter 3, the interest rate did not affect the demand for goods. In the chapter 5 we will abandon this simplification and introduce the interest rate through the investment function in our model of equilibrium in the goods market.

Investment, Sales, the Interest Rate and Output In this chapter, we capture the effects of two factors affecting investment: The level of sales (+) The interest rate (-) I = I (Y , i ) Taking into account the investment relation above, the equilibrium condition in the goods market becomes: Y = C(Y − T) + I(Y , i) + G

An Example of an Investment Function For simplicity, let us again (as for consumption) assume that investment has a linear relationship with income. We also incorporate an effect of interest rates on investment: This function corresponds to our assumptions about the derivatives of I(Y, i) with respect to Y and i.

Equilibrium in the Goods Market To determine equilibrium, use Then solve for equilibrium using Y=Z:

The demand for goods is an increasing function of output The demand for goods is an increasing function of output. Equilibrium requires that the demand for goods be equal to output. An increase in the interest rate decreases the demand for goods through the investment at any level of output. An improvement in the investors expectation for the future, increases the demand for goods through the investment

The Effects of an Increase in the Interest Rate on Output

Deriving the IS Curve Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output. The IS curve is downward sloping. If in equilibrium: then can solve for i:

Shifts of the IS Curve An increase in taxes (T) shifts the IS curve to the left. A decrease in government spending (G) shifts the IS curve to the left. A decrease in consumer confidence (co ) shifts the IS curve to the left. A deterioration in investors expectation for the future (bo ) shifts the IS curve to the left. An increase in the sensitivity of investments to the interest rate (b2 ) shifts the IS curve to the left.

Financial Markets and the LM Relation The interest rate is determined by the equality of the supply of and the demand for money: M = nominal money stock €YL(i) = demand for money €Y = nominal income i = nominal interest rate

Equilibrium in the Financial/Money Market 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: Nominal money supply is equal to the nominal money demand Real money supply is equal to the real money demand

The Effects of an Increase in Income on the Interest Rate An increase in income leads, at a given interest rate, to an increase in the demand for money. Given the money supply, this leads to an increase in the equilibrium interest rate. Notice that now the increase is in real income (Y), not nominal income (€Y).

Deriving the LM Curve Equilibrium in financial markets implies that an increase in income leads to an increase in the interest rate. The LM curve is upward-sloping. Y level real income corresponds with i rate of interest Y’ level real income corresponds with i’ rate of interest.

Shifts of the LM Curve An increase in the money supply leads the LM curve to shift down.

Putting the IS and the LM Relations Together (The IS-LM Model) Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output. Equilibrium in financial markets implies that an increase in output leads to an increase in the interest rate. When the IS curve intersects the LM curve, both goods and financial markets are in equilibrium.

Fiscal Policy, Activity, and the Interest Rate Fiscal policy affects the IS curve, not the LM curve. Recall from the chapter 3. T - G gives us the budget balance. If T > G there is a budget surplus If T < G there is a budget deficit If T = G there is a balanced budget Fiscal contraction, or fiscal consolidation, refers to fiscal policy that reduces the budget deficit /or increases the budget surplus. An increase in the deficit /or decrease in the surplus is called a fiscal expansion.

The Effects of a Contractionary Fiscal Policy A fiscal contraction (increase in taxes or decrease in government spending) shifts the IS curve to the left, and leads to a decrease in the equilibrium level of output and the equilibrium interest rate.

Monetary Policy, Activity, and the Interest Rate Monetary contraction, or monetary tightening, refers to a decrease in the money supply. An increase in the money supply is called monetary expansion. Monetary policy does not affect the IS curve, only the LM curve. For example, an increase in the money supply shifts the LM curve down. Monetary expansion leads to higher output and a lower interest rate.