1. IS-LM MODEL Eva Hromádková, 12.4 2010 0VS452 + 5EN253 Lecture 8 – part II

2. Overview of Lecture 8 – part II IS-LM model of AD curve:  Model for AD curve => analysis of stabilization policies  IS curve – goods market  Fiscal policy – expenditures and taxes  LM curve – money market  Monetary policy – money supply  Equilibrium – interest rates 2

3. IS-LM model Context 3  We have already introduced the model of aggregate demand (QTM) and aggregate supply.  Long run  prices flexible  output determined by factors of production & technology  unemployment equals its natural rate  Short run  prices fixed  output determined by aggregate demand  unemployment is negatively related to output

4. IS-LM model Context II 4  Today we will develop IS-LM model, the theory that explains the aggregate demand curve  First, we focus on the short run and assume hat price level is fixed  Then, we allow price to be flexible, and derive AD curve  Finally, we analyze the effect of fiscal and monetary policy on the most important macroeconomic aggregates – output and unemployment

5. IS curve Keynesian cross 5  A simple closed economy model in which income is determined by expenditure. (due to J.M. Keynes)  Notation: I = planned investment E = C + I + G = planned expenditure Y = real GDP = actual expenditure  Difference between actual & planned expenditure: unplanned inventory investment

6. IS curve Elements of the Keynesian cross 6 Consumption function:C = Ca + MPC*(Y-T) Govt. policy variables:G, T Investment:I = I(r) Planned expenditure:E = C(Y-T) + I(r) + G (aggregate demand) Equilibrium:Y = E

7. IS curve Graphing planned expenditure 7 income, output, Y E planned expenditure E =C +I +G Slope is MPC

8. IS curve Graphing the equilibrium condition 8 income, output, Y E planned expenditure E =Y 45 º

9. IS curve Equilibrium value of income 9 E>Y: depleting inventories => produce more E produce less income, output, Y E planned expenditure E =Y E>Y E<Y

10. IS curve Fiscal policy 10  Fiscal stimulus:  Increase in government expenditures  Cut taxes  Increase transfer payments  Fiscal restraint:  Decrease in government expenditures  Increased taxes  Decreased transfer payments

11. IS curve Increase in government purchases 11 Y E E =Y E =C +I +G 1 E 1 = Y 1 E =C +I +G 2 E 2 = Y 2 YY GG Looks like  Y>  G

12. IS curve Why is change in Y > change in G? 12  Def: Government purchases multiplier:  Initially, the increase in G causes an equal increase in Y:  Y =  G.  But  Y   C (Y-T)  further  Y  further  C  further  Y  So the government purchases multiplier will be greater than one.

13. IS curve Change in G - Sum up changes in expenditure 13

14. IS curve Increase in taxes 14 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

15. IS curve Change in T - Sum up changes in expenditure 15 equilibrium condition in changes I and G exogenous Solving for  Y : Final result:

16. IS curve Tax multiplier Question: how is this different from the government spending multiplier considered previously? The tax multiplier: …is negative: An increase in taxes reduces consumer spending, which reduces equilibrium income. …is smaller than the govt spending multiplier: (in absolute value) Consumers save the fraction (1-MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G. 16

17. IS curve How to derive the IS curve I 17 def: a graph of all combinations of r and Y that result in goods market equilibrium, i.e. actual expenditure (output) = planned expenditure The equation for the IS curve is: Y = C(Y-T) + I(r) + G The IS curve is negatively sloped. Intuition: A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending (E ). To restore equilibrium in the goods market, output (a.k.a. actual expenditure, Y ) must increase.

18. Y2Y2 Y1Y1 Y2Y2 Y1Y1 IS curve How to derive the IS curve II  r   I Y E r Y E =C +I (r 1 )+G E =C +I (r 2 )+G r1r1 r2r2 E =Y IS II  E E  Y Y

19. Y2Y2 Y1Y1 Y2Y2 Y1Y1 IS curve Fiscal policy and IS curve – example of increase in G At given value of r,  G   E   Y Y E r Y E =C +I (r 1 )+G 1 E =C +I (r 1 )+G 2 r1r1 E =Y IS 1 The horizontal distance of the IS shift equals IS 2 …so the IS curve shifts to the right. YY

20. LM curve How to build the LM curve 20 The theory of liquidity preference:  Developed by John Maynard Keynes.  A simple theory in which the interest rate is determined by money supply and money demand.

21. LM curve Money supply M/P real money balances r interest rate The supply of real money balances is fixed.

22. LM curve Money demand 22 M/P real money balances r interest rate L (r,Y ) The demand for real money balances is negatively dependent on interest rate.

23. LM curve Equilibrium 23 M/P real money balances r interest rate L (r,Y ) r1r1 The interest rate adjusts to equate the supply and demand for money

24. LM curve Monetary policy – How can CB affect the interest rate? 24 M/P real money balances r interest rate L (r,Y) r1r1 r2r2 To reduce r, central bank reduces M. In reality, this is hardly he case. More used technique = change of discount rate.

25. LM curve How to derive LM curve? 25 The LM curve is a graph of all combinations of r and Y that equate the supply and demand for real money balances. The equation for the LM curve is: The LM curve is positively sloped. Intuition: An increase in income raises money demand. Since the supply of real balances is fixed, there is now excess demand in the money market at the initial interest rate. The interest rate must rise to restore equilibrium in the money market.

26. LM curve How to derive LM curve II M/P r L (r, Y1 )L (r, Y1 ) r1r1 r2r2 r Y Y1Y1 r1r1 r2r2 LM 1 (a) The market for real money balances (b) The LM curve LM 2

27. IS-LM model Equilibrium The short-run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods & money markets: Y r IS LM Equilibrium interest rate Equilibrium level of income

28. slide 28 causing output & income to rise. IS 1 IS-LM model Fiscal policy: An increase in government purchases 1. IS curve shifts right Y r LM r1r1 Y1Y1 IS 2 Y2Y2 r2r2 1. 2. This raises money demand, causing the interest rate to rise… 2. 3. …which reduces investment, so the final increase in Y 3.

29. slide 29 IS 1 1. IS-LM model Fiscal policy: 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 1. 2. …so the effects on r and Y are smaller for a  T than for an equal  G. 2.

30. slide 30 2.…causing the interest rate to fall IS IS-LM model 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.