Lecture 4 Open Economy Macroeconomics: IS-LM Model

The IS-LM Model The IS/LM model is a macroeconomic tool that demonstrates the relationship between interest rates and real output in the goods and services market and the money market. The intersection of the IS and LM curves is the "General Equilibrium" where there is simultaneous equilibrium in both markets. IS/LM stands for Investment Saving / Liquidity preference Money supply.

THE IS (Investment = Savings) CURVE Inflation and inflationary expectations are assumed to be stable. The IS curve derives a relationship between interest rates and income in the short run An increase in the interest rate reduces investment by making it more expensive for firms to borrow money to make investment purchases and also by increasing the opportunity cost for those who plan to finance investment projects using their own funds.

the relationship between Y and r that ensure that the goods market is in equilibrium: spending=production. Note that when interest rates are high, investment falls and therefore Y must fall as well; the IS curve should show a negative relationship between r 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.

a steep IS curve means that Y does not respond very much to r. In other words, a change in the real interest rate does not have a significant impact on GDP.

Movements Along the Curve When interest rates decrease, spending rises and as a result output increases as well. This is reflected in a movement to a lower point on the IS curve where interest rates are lower and output is higher. Conversely, when interest rates increase, spending falls and as a result output decreases as well. This is reflected in a movement to a higher point on the IS curve where interest rates are higher and output is lower.

Parallel Shifts of the IS Curve Increases in (1) consumer confidence, (2) investor confidence, (3) government purchases, (4) net exports will raise expenditure, and therefore production of goods and services, shifting the IS curve out (rightwards). A reduction in lump-sum taxes will increase expenditure on goods and services and therefore increase output as well. This will cause the IS curve to shift out.

Shifts of the IS Curve: T & G An increase in taxes shifts the IS curve to the left.

The Goods Market and the IS Relation IS Curve captures the effect of nominal interest rate i on output Y, for given values of T and G. (tax and government purchase). Investment demand depends negative on interest rate. Hence, when i increase, the investment and then the total demand will fall. So will the total output Y. Therefore, IS curve is downward sloping.

We derived the IS curve, the first part of the model of economic fluctuations known as the IS-LM model. The IS Curve summarized all the combinations of interest rates and GDP that clear the market for goods and services in the economy. The IS curve by itself cannot give us the value of output in the economy because it does not have anything to say about the level of interest rates in the economy. Hence we need to derive the LM curve and study its intersection with the IS curve.

Financial Markets and the LM (Liquidity Preference = Money Demand) curve LM curve is a relationship that describes the behavior of the money market, which determines interest rates in the economy. The LM curve consists of the combinations of income and interest rates that clear the market for money balances (i.e. equate money demand and money supply). 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

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 (Why? Because higher i implies a higher Opp. Cost of holding money). LM Curve captures the effect of output Y on nominal interest rate i, for given values of M (nominal money supply) and P (in short run price is assumed to be fixed).

When r is high, the demand for money is low because money pays no interest – the opportunity cost of holding money instead of other financial assets rises. When Y is high the demand for money is high, richer people who buy more goods are likely to hold more money. When prices P are high the demand for money is high since people need more money to complete their transactions. Higher total output implies higher transaction demand. So for given level of nominal money supply, high demand implies the interest rate that clear the money market has to increase. So when Y increases, the nominal interest rate i increases. Therefore, LM curve is upward sloping.

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 The Derivation of 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.

MOVEMENTS ALONG THE LM CURVE Changes in money demand brought about by changes in Y or by changes in r are reflected as movements along the LM curve. When income decreases, money demand falls and as a result interest rates must decrease to restore money market equilibrium. When income increases, money demand rises and as a result interest rates must increase to restore money market equilibrium.

If the CB increases the money supply (expansionary monetary policy) then from the equation we can see that the vertical (r) intercept will be lower and the horizontal (Y) intercept will be larger, i.e. the LM curve shifts out (to the right). An increase in the price level has the same effect as a decrease in the money supply - it shifts the LM curve in (to the left). An increase in exogenous money demand raises the vertical intercept and makes the horizontal intercept smaller: the LM curve shifts in (to the left).

The basic intuition is that the movement of interest rates depends on the relationship between money demand and money supply. Exogenous changes that bring about excess money demand, i.e. drive money demand above money supply, cause interest rates to rise in order to lower money demand and equilibrate money demand and supply. The LM curve will shift in. These changes include a fall in money supply, a rise in prices or an increase in exogenous money demand. Exogenous changes that bring about excess money supply, i.e. drive money supply above money demand cause interest rates to fall in order to raise money demand and equilibrate money demand and supply. The LM curve will shift out. These changes include an increase in money supply, a fall in prices or a decrease in exogenous money demand.

An increase in the supply of money by the CB will result in an excess supply of money. This will cause the LM curve to shift outwards in order to restore equilibrium. An increase in the price level will raise money demand and result in an excess demand for money. This will cause the LM curve to shift inwards to restore equilibrium

Another way of intuitively understanding the LM curve is as follows. When there is an excess supply of money, people are more likely to put the extra money into non monetary financial assets, so issuers of those assets can offer lower rates of interest yet still attract buyers. Conversely, when there is an excess demand for money, people are less likely to put money into non monetary financial assets, so issuers of those assets must offer higher rates of interest to attract buyers.

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

IS-LM model It is a short run model of the determination of output. The model has two main parts: an IS curve that summarizes all the combinations of Y and r consistent with goods market equilibrium and an LM curve that summarizes all the combinations of Y and r that are consistent with money market equilibrium. Since the IS curve summarizes all combinations of income and interest rates that clear the market for goods and services while the LM curve summarizes all combinations of income and interest rates that clear the money market, equilibrium income and the equilibrium interest rate are at the intersection of the two curves.

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.

Anywhere other than the intersection we would expect there to be changes in Y or r that restore either goods market or money market equilibrium. Generally, we believe that the money market adjusts very quickly so the economy will rarely be off the LM curve. However, it will not stay off the IS curve for very long either as firms can adjust production to bring it in line with demand.

Fiscal Policy, Activity, and the Interest Rate Fiscal contraction, or fiscal consolidation, refers to fiscal policy that reduces the budget deficit. An increase in the deficit is called a fiscal expansion. Taxes affect the IS curve, not the LM curve.

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.

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 The Effects of a Monetary Expansion Monetary expansion leads to higher output and a lower interest rate.

Movement in Interest Rate 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 taxes left none down Decrease in taxes right up Increase in spending Decrease in spending Increase in money Decrease in money

The Clinton-Greenspan Policy Mix 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

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

Effects of Monetary and Fiscal Policy in the IS/LM Model Expansionary fiscal policy shifts the IS curve to the right Contractionary fiscal policy shifts the IS curve to the left Monetary Policy Expansionary monetary policy shifts the LM curve to the right Contractionary monetary policy shifts the LM curve to the left

Fiscal Policy and Crowding Out When government expenditures increase, output and income begin to increase. The increase in income increases the demand for money. The increase in money demand increases the interest rate. Higher interest rates cause a decrease in investment, offsetting some of the expansionary effect of the increase in government spending.

Partial Crowding Out LM $1000 Real Interest Rate (%) IS1 IS0 $6000 1. Let’s assume if government spending increases by $500, IS increases by $1000. 2. The increase in income increases money demand which increases interest rates from 4% to 5%. LM 3. The increase in the interest rate causes a decrease in investment so that the increase in income is only $600, less that the full multiplier effect. $1000 Real Interest Rate (%) 5% 4% IS1 IS0 $6000 $6600 $7000 Aggregate Output

Full Crowding Out LM Real Interest Rate (%) $1000 IS1 IS0 $6000 $7000 1. Again government spending increases by $500, and the IS increases by $1000. 2. If the demand for money is totally insensitive to the interest rate, the interest rate increases from 4% to 9%. LM 9% 3. The increase in the interest rate causes a decrease in investment that completely offsets the increase in government spending. Real Interest Rate (%) $1000 4% IS1 IS0 $6000 $7000 Aggregate Output

Ineffective Fiscal Policy When complete crowding out occurs, fiscal policy is ineffective, changing only interest rates, not output. Crowding out is greater if: Money demand is very sensitive to income changes Money demand is not very sensitive to interest rate changes

Monetary Policy in the IS/LM Model The CB increases the money supply which decreases interest rates and increases investment and output. In a liquidity trap, increases in the money supply do not decrease interest rates, so investment and output do not increase. LM0 LM0 Real Interest Rate (%) Real Interest Rate (%) LM1 LM1 r0 r0 r1 IS IS Y0 Y1 Y0 Aggregate Output Aggregate Output

Ineffective Monetary Policy Investment is not sensitive to the interest rate If investment does not respond to interest rate changes (the IS curve is steep), monetary policy in ineffective in changing output. Liquidity trap If increases in the money supply fail to lower interest rates, monetary policy is ineffective in increasing output.

Short-Run Outcomes of Policy

Examples of Monetary and Fiscal Policies

Anticipation of Policy Problems The IS/LM model does not take into account the effect of people’s expectations of policy actions. If investors expect the Fed to increase the money supply and decrease interest rates, they will buy bonds now. The increase in demand for bonds increases their price and decreases interest rates before the money supply is actually increased.

Monetary Policy Tools and Credit Condition Problems The IS/LM model assumes that interest rates are the only determinant of investment. Investment also depends on credit conditions, the willingness of banks to lend independent of interest rates. If banks raise their lending standards, investment may not respond to expansionary monetary policy.

Implementation Problems of Monetary and Fiscal Policy Uncertainty about Potential Output Information Lag Policy Implementation Lag

Uncertainty About Potential Output One macroeconomic policy goal is to keep output as close to potential as possible. In the real world, economists aren’t sure what potential output is. If policymakers use contractionary policy when the economy is actually below potential, they create unemployment. Using expansionary policy above potential output will cause inflation.

Information Lag The IS/LM model assumes that policymakers see what is happening in the economy and can instantly alter policies to fix any problem. In the real world there is an information lag, a delay between a change in the economy and knowledge of that change.

Policy Implementation Lag The policy implementation lag is the delay between the time policymakers recognize the need for a policy action and when the policy is instituted. Fiscal policy has a large implementation lag because policy must be formulated and legislation passed by Congress and the President. Monetary policy has a shorter implementation lag because the Federal Open Market Committee decides monetary policy.