# Goods & Financial Markets: The IS-LM Model

## Presentation on theme: "Goods & Financial Markets: The IS-LM Model"— Presentation transcript:

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

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):

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.

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

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

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?

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)

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:

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

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

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

The IS-LM Model Exercises
Equilibrium Requires:

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

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

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 The fiscal contraction lowered interest and output IS (T) IS´ (T´ > T) Y Output, Y

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

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

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) New equilibrium A´: i´ & Y´ Monetary expansion lowered i & increased Y IS Y Output, Y

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

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

Using a Policy Mix The Clinton-Greenspan Policy Mix Interest Rate, i
LM 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 New equilibrium i´, Y´ IS IS´ Y Output, Y

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%)

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

Changes in output adjust slowly to changes in the goods market (IS) Interest rates adjust instantaneously to changes in the financial markets (LM)

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 iA Yb Interest rates adjust instantaneously IS iA A Ya Ya Output, Y Output, Y

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 i rises to i´´ A Higher i reduces demand and output slowly A´´ to A´ i Equilibrium restored at A´: i´, Y´ IS Y Output, Y

Monetary policy changes interest rates rapidly and output slowly The Central Bank must consider the output lag when implementing monetary policy

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

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

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

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

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

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