Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI 1. 1.Blanchard,O.,2003,“Macroeconomics”, Third edition, International edition 2. 2.Dornbush,R.,Fischer,S and Startz, R., 2001,“Macroeconomics”, 8th edition, New York: McGraw-Hill DeLong JB., 2002,”Macroeconomics”, McGraw- Hill Mankiw,N.Gregory.,2002,”Macroeconomics”, 5nd edition, New York : Worth

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI

In This Session, we will use the IS-LM model to : See how policies and shocks affect income and the interest rate in the short run when prices are fixed Effect of Fiscal Policy to Macroeconomic Effect of Monetary Policy to Macroeconomic Derive the aggregate demand curve Composition of National Output IN THIS CHAPTER YOU WILL LEARN

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI The intersection determines the unique combination of Y and r that satisfies equilibrium in both markets. The LM curve represents money market equilibrium. Equilibrium in the IS-LM Model The IS curve represents equilibrium in the goods market. IS Y r LM r1r1 Y1Y1

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Policy analysis with the IS-LM Model Policymakers can affect macroeconomic variables with fiscal policy: G and/or T monetary policy: M We can use the IS-LM model to analyze the effects of these policies. IS Y r LM r1r1 Y1Y1

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Definition of Fiscal Policy (Discretionary) fiscal policy: the deliberate attempt to achieve macroeconomic goals using changes in federal government spending &/or taxes. The goals: - full employment, - low inflation, - long run economic growth

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Fiscal Policy in Aggregate Expenditure AE Fiscal expansion Fiscal contraction or Fiscal consolidation affects the IS curve, not the LM curve. The equation for the IS curve is: Equilibrium: Supply of Goods Demand for Goods (AD)

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI

In Equilibrium

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI EXPANSIONARY FISCAL POLICY Expansionary fiscal policy is used to eliminate a contractionary gap Contractionary Gap The gap between actual equilibrium real GDP(Y) & the full employment level of real GDP(Y F ) when Y<Y F A contractionary gap occurs when the actual level of planned aggregate expenditures(AE P ) is less than the full employment level of planned aggregate expenditures. AE P U F

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI EXPANSIONARY FISCAL POLICY

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Type of Expansionary fiscal policy : EXPANSIONARY FISCAL POLICY

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI An increase in government purchases Y E E =Y E =C +I +G 1 E 1 = Y 1 E =C +I +G 2 E 2 = Y 2 YY At Y 1, there is now an unplanned drop in inventory… …so firms increase output, and income rises toward a new equilibrium GG  G   E  AE Curve Shipt to the left (up)    Y

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI  G   E  AE Shift to the left   Y  IS curve shift to the right Y r E Y Y=E Y1Y1 Y1Y1 Keynesian Cross IS 2 I E(G 1 ) M/P r L (r, Y1 )L (r, Y1 ) r1r1 MSMS LM E(G 2 ) Y2Y2 Y2Y2 Remem ber  Y   M d IS 1 L (r, Y2 )L (r, Y2 ) r2r2 Crowding-out effect An increase in government purchases

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI causing output & income to rise. IS 1 An increase in government purchases 1. IS curve shifts right Y r LM r1r1 Y1Y1 IS 2 Y2Y2 r2r This raises money demand, causing the interest rate to rise… …which reduces investment, so the final increase in Y 3.

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI EXPANSIONARY FISCAL POLICY

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Crowding Out Crowding out: reduction in private sector spending as a resul to fhigher interest rates following expansionary fiscal policy Occurs when fiscal policy is used to eliminate a contractionary gap indirect (interest rate) versus direct (public hospital instead of private hospital) The Crowding out Process :

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Decrease in taxes (Tax Cut) Y E E =Y E =C 1 +I +G E 1 = Y 1 E =C 2 +I +G E 2 = Y 2 YY At Y 1, there is now an unplanned inventory buildup… …so firms expand output, and income go up ward (increase) toward a new equilibrium  C =  MPC  T Initially, the tax decrease expand / increase consumption, and therefore E: T↓  Y d  C  E  AE Curve Shipt to the left (up)   Y

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI IS 1 1. A tax cut Y r LM r1r1 Y1Y1 IS 2 Y2Y2 r2r2 Because consumers save (1  MPC) of the tax cut, the initial boost in spending is smaller for  T than for an equal  G… and the IS curve shifts by …so the effects on r and Y are smaller for a  T than for an equal  G. 2.

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI EXPANSIONARY FISCAL POLICY

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI CONTRACTIONARY FISCAL POLICY Contractionary fiscal policy is used to eliminate a Expansionary gap Expansionary Gap The gap between actual equilibrium real GDP(Y) & the full employment level of real GDP(Y F ) when Y > Y F A expansionary gap occurs when the actual level of planned aggregate expenditures(AE P ) is more than the full employment level of planned aggregate expenditures. AE P > AE PF → Y > Y F & U < U F

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Expansionary gaps are expected to result in an increase in the price level & higher inflation. CONTRACTIONARY FISCAL POLICY

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI The government can use contrasionary fiscal policy in the form of: CONTRACTIONARY FISCAL POLICY

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Decrease in government purchases Y E E =Y E =C +I +G 2 E 2 = Y 2 E =C +I +G 1 E 1 = Y 1 YY At Y 1, there is now an unplanned drop in inventory… …so firms decrease output, and income falls toward a new equilibrium GG ↓G  ↓E  AE Curve Shipt to the right (down) ↓  ↓Y

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI causing output & income to falls. IS 2 Decrease in government purchases 1. IS curve shifts left Y r LM r2r2 Y2Y2 IS 1 Y1Y1 r1r This decrease money demand, causing the interest rate to falls… …Decrease in Y 3.

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI CONTRACTIONARY FISCAL POLICY

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI An increase in taxes Y E E =Y E =C 2 +I +G E 2 = Y 2 E =C 1 +I +G E 1 = Y 1 YY At Y 1, there is now an unplanned inventory buildup… …so firms reduce output, and income falls toward a new equilibrium  C =  MPC  T Initially, the tax increase reduces consumption, and therefore E: T  Y d ↓  C↓  E↓  AE Curve Shipt to the right (down) ↓  ↓Y

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI causing output & income to falls. IS 2 Tax Increase 1. IS curve shifts left Y r LM r2r2 Y2Y2 IS 1 Y1Y1 r1r This decrease money demand, causing the interest rate to falls… …Decrease in Y 3.  C =  MPC  T

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI   in A, IS curve shift to the right Algebra of Fiscal Policy

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Syarat Total differensial Algebra of Fiscal Policy

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Total differensial  G   E   Y IS Curve shift to the right  G   E   Y IS Curve shift to the left Algebra of Fiscal Policy

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI (Discretionary) monetary policy: the deliberate attempt to achieve macroeconomic goals by targeting money supply growth rates or interest rates (changes in the money supply or interest rates) The goals: - Full employment (High employment), - Low inflation, - A stable exchange rate, - Long run economic growth Definition of Monetary Policy

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI The Federal Reserve uses the size and growth rate of the money supply in order to “manage the economy” with the primary goals of: 1) avoiding recessions 2) low (or zero) inflation 3) interest rate levels that allow strong economic growth & high employment Definition of Monetary Policy

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Monetary Policy The Fed’s Tools For Controlling the Money Supply & Conducting Monetary Policy : 1.Open Market Operations

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Monetary Policy

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI 2. The Other Tools Monetary Policy

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Monetary Policy

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Monetary Policy

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Expansionary monetary policy is used to eliminate a contractionary gap Contractionary Gap and Expansionary Monetary Policy

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Contractionary Gap and Expansionary Monetary Policy

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Contractionary Gap and Expansionary Monetary Policy

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI I=(a+I P ) r Y Y1Y1 I1I1 I M/P r r2r2 M S1 Y2Y2 I2I2 L (r, Y1)L (r, Y1) r1r1 E(I1) Y=E E M S2 E(I2) LM 1 LM 2 Contractionary Gap and Expansionary Monetary Policy

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI 2.…causing the interest rate to fall IS Monetary Policy: an increase in M 1.  M > 0 shifts the LM curve down (or to the right) Y r LM 1 r1r1 Y1Y1 Y2Y2 r2r2 LM 2 3.…which increases investment, causing output & income to rise.

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Interaction between monetary & fiscal policy Model: monetary & fiscal policy variables (M, G and T ) are exogenous Real world: Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa. Such interaction may alter the impact of the original policy change.

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI The CB’s response to  G > 0 Suppose Govt increases G. Possible CB responses: 1. hold M constant 2. hold r constant 3. hold Y constant In each case, the effects of the  G are different:

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI If Govt raises G, the IS curve shifts right IS 1 Response 1: hold M constant Y r LM 1 r1r1 Y1Y1 IS 2 Y2Y2 r2r2 If CB holds M constant, then LM curve doesn’t shift. Results:

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI If Govt raises G, the IS curve shifts right IS 1 Response 2: hold r constant Y r LM 1 r1r1 Y1Y1 IS 2 Y2Y2 r2r2 To keep r constant, CB increases M to shift LM curve right. LM 2 Y3Y3 Results:

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI If Govt raises G, the IS curve shifts right IS 1 Response 3: hold Y constant Y r LM 1 r1r1 IS 2 Y2Y2 r2r2 To keep Y constant, CB reduces M to shift LM curve left. LM 2 Results: Y1Y1 r3r3

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Close Economy – Goods Markets

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Close Economy – Goods Markets

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Total Diferensial: Close Economy – Money Markets

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI EQUILIBRIUM IS – LM MODEL

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI EQUILIBRIUM IS – LM MODEL

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Using a Policy Mix The combination of monetary and fiscal polices is known as the monetary-fiscal policy mix, or simply, the policy mix. The Effects of Fiscal and Monetary Policy. Shift of IS Shift of LM Movement of Output Movement in Interest Rate Increase in taxesleftnonedown Decrease in taxesrightnoneup Increase in spendingrightnoneup Decrease in spending leftnonedown Increase in moneynonedownupdown Decrease in moneynoneupdownup

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI IS-LM and Aggregate Demand So far, we’ve been using the IS-LM model to analyze the short run, when the price level is assumed fixed. However, a change in P would shift the LM curve and therefore affect Y. The aggregate demand curve captures this relationship between P and Y

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Y1Y1 Y2Y2 Deriving the AD curve Y r Y P IS LM(P 1 ) LM(P 2 ) AD P1P1 P2P2 Y2Y2 Y1Y1 r2r2 r1r1 Intuition for slope of AD curve:  P   (M/P )  LM shifts left  r r  I I  Y Y

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Monetary policy and the AD curve Y P IS LM(M 2 /P 1 ) LM(M 1 /P 1 ) AD 1 P1P1 Y1Y1 Y1Y1 Y2Y2 Y2Y2 r1r1 r2r2 The CB can increase aggregate demand:  M  LM shifts right AD 2 Y r  r r  I I   Y at each value of P

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Y2Y2 Y2Y2 r2r2 Y1Y1 Y1Y1 r1r1 Fiscal policy and the AD curve Y r Y P IS 1 LM AD 1 P1P1 Expansionary fiscal policy (  G and/or  T ) increases agg. demand:  T   C  IS shifts right   Y at each value of P AD 2 IS 2

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Deriving AD curve with algebra

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Deriving AD curve with algebra

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Deriving AD curve with algebra

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Deriving AD curve with algebra

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Deriving AD curve with algebra

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Deriving AD curve with algebra

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Deriving AD curve with algebra

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Deriving AD curve with algebra

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Deriving AD curve with algebra

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Chapter summary 1. IS-LM model  a theory of aggregate demand  exogenous: M, G, T, P exogenous in short run, Y in long run  endogenous: r, Y endogenous in short run, P in long run  IS curve: goods market equilibrium  LM curve: money market equilibrium

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI Chapter summary 2. AD curve  shows relation between P and the IS-LM model’s equilibrium Y.  negative slope because  P   (M/P )   r   I   Y  expansionary fiscal policy shifts IS curve right, raises income, and shifts AD curve right  expansionary monetary policy shifts LM curve right, raises income, and shifts AD curve right  IS or LM shocks shift the AD curve

Copyright © 2005 Prepared By Dr. Dede Ruslan, M.SI The End