Goods and Financial Markets: The IS-LM Model

How are Output and the Interest Rate Jointly Determined in the Short Run? Output and the interest rate are determined by simultaneous equilibrium in the goods and money markets. In the short run, we assume that production responds to demand without changes in price (i.e., price is fixed), so output is determined by demand. The determination of output is the fundamental issue in macroeconomics. The interest rate affects output (through investment) and output affects the interest rate (through money demand), so it is necessary to consider the simultaneous determination of output and the interest rate.

The Goods Market and the IS Relation 5-1 Equilibrium in the goods market exists when production, Y, is equal to the demand for goods, Z. In the simple model developed in chapter 3, the interest rate did not affect the demand for goods. The equilibrium condition was given by:

Investment, Sales, and the Interest Rate In this chapter, we capture the effects of two factors affecting investment: The level of sales (+) The interest rate (-)

The Determination of Output Taking into account the investment relation above, the equilibrium condition in the goods market becomes: Notice we don’t assume that the relation between C and Y, or between I and Y, has to be linear.

The Determination of Output Equilibrium in the Goods Market The demand for goods is an increasing function of output. Equilibrium requires that the demand for goods be equal to output. When the ZZ line is flatter than the 45-degree line, an increase in output leads to a less than one-for-one increase in demand. Note: The ZZ line is flatter than the 45° line because the econometric evidence tells us that increases in consumption and investment do not exceed the corresponding increase in output.

Deriving the IS Curve The Effects of an Increase in the Interest Rate on Output An increase in the interest rate decreases the demand for goods at any level of output. By the multiplier effect, output falls. When the ZZ line is flatter than the 45-degree line, an increase in output leads to a less than one-for-one increase in demand.

Deriving the IS Curve In Words: i rises  Investment falls  The ZZ curve shifts down  Equilibrium output falls.  In the goods market, there is an inverse relation between i and Y.

Deriving the IS Curve The Derivation of 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.

Shifts of the IS Curve Shifts of the IS Curve An increase in taxes shifts the IS curve to the left.

Shifts of the IS Curve The IS curve shifts to the right if: Taxes fall, Government spending rises, Autonomous Investment rises, (that is, I rises for reasons besides i or Y) Autonomous Consumption rises. It does not shift when i or Y change.

Every point on the IS curve is an equilibrium for the goods market. Z ZZ, High interest rate Z ZZ, Medium Interest Rate Y Y Interest, i Z ZZ, Low Interest Rate Y Income, Y

Every point on the IS curve is an equilibrium for the goods market. Z ZZ, Medium Interest Rate Interest, i IS’ (high consumer confidence) IS (low consumer confidence) Income, Y

Financial Markets and the LM Relation 5-2 The interest rate is determined by the equality of the supply of and the demand for money: M = nominal money stock PYL(i) = demand for money PY = $Y = nominal income i = nominal interest rate

Real Money, Real Income, and the Interest Rate 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:

Real Money, Real Income, and the Interest Rate The book uses $Y = PY From chapter 2, recall that Nominal GDP = Real GDP multiplied by the GDP deflator: Equivalently:

Deriving the LM Curve Suppose Real Income increases: Y rises  People demand more money for transactions  Md shifts out. If Ms is vertical,  i rises … … until the quantity of money demanded equals the quantity of money supplied, which is fixed.

Deriving the LM Curve 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.

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.

Shifts of the LM Curve Shifts of the LM Curve If the Central Bank increases the money supply, the LM curve shifts down. The LM curve shifts in response to any factor that affects the money market, except i or Y.

Every point on the LM curve is an equilibrium for the money market. M/P interest, i Md, High income Ms Ms interest, i Interest, i Md, Medium income M/P Ms interest, i Md, Low income M/P Income, Y

Putting the IS and the LM Relations Together 5-3 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 contraction refers to fiscal policy that reduces the budget deficit. An increase in the deficit is called a fiscal expansion. Consider an increase in taxes. Taxes affect the IS curve, not the LM curve.

Fiscal Policy, Activity, and the Interest Rate Suppose the government raises taxes. Higher Taxes affect the IS curve: They reduce disposable income, so that there is less consumption at every level of Y. Z ZZ i ZZ Y falls at every level of interest. IS Y IS’ Y

Fiscal Policy, Activity, and the Interest Rate Suppose the government raises taxes. Higher Taxes do not affect the LM curve: Neither disposable income nor taxes appear in the money market. LM M/P i Md Ms i i stays the same at every level of Y. Y

Fiscal Policy, Activity, and the Interest Rate The Effects of an Increase in Taxes An increase in taxes shifts the IS curve to the left, and leads to a decrease in the equilibrium level of output and the equilibrium interest rate.

Fiscal Policy, Activity, and the Interest Rate Higher taxes shift the IS curve to the left and leave the LM curve unchanged. At the old level of interest rates, income has fallen. This causes the Md curve to move to the left in the money market. This causes a movement along the LM curve. The money market changed due to a change in Y, so the Md curve shifts but the LM curve does not shift. Equilibrium is restored at lower i and lower Y.

Fiscal Policy, Activity, and the Interest Rate Higher taxes and Investment. On the one hand, higher taxes lead to lower interest rates and higher investment. On the other, higher taxes lead to lower economic activity, … and less investment. Also, lower economic activity reduces saving, reducing the amount of funds available for investment.

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 Policy, Activity, and the Interest Rate Suppose the Central Bank expands the Money Supply. Higher Ms does not affect the IS curve: The Money Supply does not appear in the goods market. Z ZZ i Y stays the same at any i. IS Y Y

Monetary Policy, Activity, and the Interest Rate Suppose the Central Bank expands the Money Supply. Higher Ms shifts the LM curve to the right: A greater money supply lowers the interest rate at every level of income. LM Ms i i LM Ms’ i falls at every level of Y. Md Y M/P

Monetary Policy, Activity, and the Interest Rate The Effects of a Monetary Expansion Monetary expansion leads to higher output and a lower interest rate.

Monetary Policy, Activity, and the Interest Rate Higher Money Supply shifts the LM curve to the right and leave the IS curve unchanged. At the old level of income, interest rates have fallen. This causes Investment to increase, shifting the ZZ curve up in the goods market. The increase in income causes a movement along the IS curve. The goods market changed due to a change in i, so the ZZ curve shifts but the IS curve does not shift. Equilibrium is restored at lower i and higher Y.

Policy, Activity, and the Interest Rate Table 5-1 The Effects of Fiscal and Monetary Policy. Shift of IS Shift of LM Movement of 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

Using a Policy Mix 5-4 The combination of monetary and fiscal polices is known as the monetary-fiscal policy mix, or simply, the policy mix.

The Clinton-Greenspan Policy Mix Table 5-2 Selected Macro Variables for the United States, 1991-1998 1991 1992 1993 1994 1995 1996 1997 1998 Budget surplus (% of GDP) (minus sign = deficit) 3.3  4.5  3.8  2.7  2.4  1.4  0.3 0.8 GDP growth (%) 0.9 2.7 2.3 3.4 2.0 3.9 3.7 Interest rate (%) 7.3 5.5 3.3 5.0 5.6 5.2 4.8 Over the 90’s, fiscal policy was contractionary and monetary policy was expansionary. This led to low interest rates and high output growth.

The Clinton-Greenspan Policy Mix Deficit Reduction and Monetary Expansion The appropriate combination of deficit reduction and monetary expansion can achieve a reduction in the deficit without adverse effects on output.

German Unification and the German Monetary-Fiscal Tug of War Table 5-2 Selected Macro Variables for West Germany, 1988-1991 1991 1992 1993 1994 GDP growth (%) 3.7 3.8 4.5 3.1 Investment growth (%) 5.9 8.5 10.5 6.7 Budget surplus (% of GDP) (minus sign = deficit) 2.1 0.2 1.8 2.9 Interest rate (%) 4.3 7.1 9.2

German Unification and the German Monetary-Fiscal Tug of War The Monetary-Fiscal Policy Mix of Post-Unification Germany

How does the IS-LM Model Fit the Facts? 5-5 The Empirical Effects of an Increase in the Federal Funds Rate In the short run, an increase in the federal funds rate leads to a decrease in output and an decrease in production, But so that, for a while, sales are below production and inventories accumulate. The two dotted lines and the tinted space between them gives us a confidence band, a band within which the true value of the effect lies with 60% probability.

How does the IS-LM Model Fit the Facts? The Empirical Effects of an Increase in the Federal Funds Rate In the short run, an increase in the federal funds rate leads to an increase in unemployment, but little effect on the price level. The two dotted lines and the tinted space between them gives us a confidence band, a band within which the true value of the effect lies with 60% probability.

How does the IS-LM Model Fit the Facts? In general, the IS-LM model seems to be a pretty good description of the short run. Econometric evidence tells us (within certain bounds of error) that contractionary monetary policy Lowers employment … without changing prices (which is what we assumed in this chapter).

What did I learn in this chapter? Tools and Concepts The IS-LM framework. The simultaneous determination of income and interest rates; how different shocks affect these two. The option of choosing alternative policy mixes to achieve macroeconomic goals. The use of “+” and “-” below the argument of a function to indicate the effect of an increase in the value of the argument on the value of the function.

What did I learn in this chapter? Remember We still assume prices are fixed, But we relax the assumptions that investment is independent of the interest rate (assumed in Chapter 3) and that nominal income is fixed (assumed in Chapter 4). Investment is also allowed to depend on output. The point of this chapter is to show how goods and financial markets are related and thus how output and the interest rate are simultaneously determined. We continue to assume the economy is closed.