Goods and Financial Markets1: IS-LM Goal: link the goods and the financial markets into a more general model that will determine the equilibrium and the equilibrium in the economy (with prices) The goods market will be represented by the curve (standing for investment-savings) The financial markets (money market) will be represented by the curve (liquidity-money) 1. The Hicks-Hansen model based on Keynes’ General Theory BlCh5

The goods market - IS curve Equilibrium condition will provide the link to the financial markets Determinants of investment: If increase, producers might want to increase their productive capacity by investing in capital goods. If , producers find that borrowing to add new capital becomes more expensive BlCh5

Equilibrium in the goods market becomes: Y = Basically When i I and Ye When i I and Ye The ZZ curve shifts now as the interest rate changes and a multiplier effect takes place If MPI is the marginal propensity to invest out of new income, assume that MPC + MPI < 1 The slope of the ZZ curve is now and the interest rate is included in the intercept BlCh5

Construction of the IS curve Z When the interest rate increases, I (Y, i) drops and the ZZ curve shifts down. The economy contracts from Ye to Y’e. E and E’ correspond to 2 combinations of i and Y, such that the good market is in equilibrium. i Y Y’e Ye i i’ i Y Y’e Ye BlCh5

The IS curve Y = Definition: All the combinations i.e. the above equation is satisfied Shift of the IS: A change in any of the in the equation will cause IS to shift. Shift variables: (confidence variables) (fiscal policy variables) BlCh5

Expansionary fiscal policy: increase in G Y=Z Z ZZ (G) When G increases by ∆G, ZZ shifts up and IS shifts to the right. An increase in T would has the opposite effect as it is contractionary. Y Ye i E i IS Y Ye BlCh5

Shifts of IS Expansionary Contractionary i G T c0 G I0 T c0 I0 IS Y BlCh5

The financial markets - LM curve Equilibrium condition1: supply of money = demand for money Ms = or Ms/P = (Ms/P is the real money supply) It is clear that both LM and IS are relations between i and Y 1. The bonds market is automatically in equilibrium when the money market is in equilibrium BlCh5

Construction of the LM curve Ms i i i0 Md(Y0) M/P Y0 Y1 Y BlCh5

The LM curve Ms = Definition: All the combinations of and such that the ( and ) are in equilibrium Shift of the LM curve: a change in the money or a change in or an exogenous shift in the money demand An in the money supply ( or a in price) is expansionary A change in the velocity of money BlCh5

Expansionary monetary policy: an increase in Ms LM i A i0 Md(Y0) M/P Y0 Y BlCh5

Shifts of LM Contractionary i LM Ms P V Ms P V Expansionary Y BlCh5

sloped, they will intercept in E determining Y and i in equilibrium. The IS-LM model Y = IS curve M/P = LM curve IS is sloped and LM is sloped, they will intercept in E determining Y and i in equilibrium. At that point, all three markets : two financial markets and the goods market, are BlCh5

The IS-LM graph i Y BlCh5

Problem # 4 IS-LM model: C = 200+ .25YD I = 150 + .25Y - 1000i G = 250 and T = 200 (M/P)d = 2Y - 8000i M/P = 1,600 IS LM BlCh5

Derive the IS curve: Y = C + I + G Y = 200 + .25Y- .25T + 150 + .25Y - 1000i + 250 = 550 + .5Y - 1000i Y - .5Y = 550 - 1000i Y (1 - .5) = 550 - 1000i Y = [1/.5] (550 -1000i) multiplier = 2 IS curve: Y = 1100 - 2000i BlCh5

Derive the LM curve: YL(i) = M/P 2Y - 8000i = 1600 8000i = 2Y - 1600 LM curve: i = Y/4000 - .2 c. Solve IS-LM for equilibrium Y Y = 1100 -2000i = 1100 - 2000(Y/4000 - .2) = 1100 - .5Y + 400 1.5Y = 1500 so Y = 1000 BlCh5

Replace equilibrium Y and i into C and I i = Y/4000 - .2 = 1000/4000 - .2 = .25 - .2 = .05 so i = 5% Replace equilibrium Y and i into C and I C = 200 + .25*1000 - .25*200 = 400 I = 150 + .25*1000 - 1000*.05 = 350 G = 250 So Y = 400 + 350 + 250 = 1000 BlCh5

Fiscal Policy Instruments: Curve affected: Effect: Expansionary: when (G-T) or G or T IS shifts to the Contractionary: when (G-T) or G or T BlCh5

A fiscal expansion The economy moves along the LM curve from A to A’ i ie A IS Ye Y BlCh5

Mechanics of fiscal expansion Goods market effects As G Y = too immediately Then C= and I = also Multiplier effect: at same i, Y reaches a higher level as IS shifts to the right Financial markets effects As Y the demand for money M = and the ward shift in Md results in a i, but this is a movement along the curve to A’. BlCh5

Effect on investment As i increases, investment is . So there are 2 opposite effects on investment as Y increases I as i increases I It means that the overall expansion due to the increase in G will be by the impact of the increase in the interest rate on investment. There is some of private investment due to the increase in government spending. BlCh5

Expansionary Fiscal Policy Y=Z Z ZZ (G) ∆G Y Ye Y” i Ms i LM i’ i’ i i IS Md M/P Y Ye Y’e BlCh5

Net effect of increase in G on investment 1. Using investmt funct as Y increases I as i increases I Net effect is ambiguous 2. Using equil condition as Y increases Sp as G increases (T - G) BlCh5

A fiscal expansion: G increases to 400 Problem # 5 cont. A fiscal expansion: G increases to 400 New IS curve: Y = 700 + .5Y - 1000i Y = [1/.5] (700 - 1000i) = 1400 - 2000i Same LM curve: i = Y/4000 - .2 Solve: Y = 1400 - 2000(Y/4000 - .2) 1.5Y = 1800 so Y = 1200 Replace in LM and we get i = .10 or 10% BlCh5

Calculate the corresponding equilibrium for C & I C = 200 + .25Y - .25T = 200 + 300 - 50 = 450 I = 150 + .25Y - 1000i = 150 + 300 - 100 = 350 Y = C + I + G = 450 + 350 + 400 = 1200 Impact of fiscal expansion: both Y and i increase. C (a function of Y) increases too. I increases when Y increases and decreases when i increases (ambiguous results overall). With these data, I does not change as the two effects neutralize each other. BlCh5

Monetary policy Instrument: Curve affected: Effect: LM shifts to the Expansionary when Ms increases LM shifts to the Contractionary when Ms is cut BlCh5

A monetary contraction LM ie A IS Y Ye BlCh5

Mechanics of a monetary contraction Open market of bonds Suppose P=1 constant - so monetary contraction in terms is equivalent to a terms one. Financial market effects As Ms drops, i - money market effect. Goods market effects As i increases, investment I = I(Y,i) is affected and Y = . BlCh5

Unambiguous: as Y drops and i increases, investment can only . Effect on investment Unambiguous: as Y drops and i increases, investment can only . Note that the money demand will shift to the left as Y drops dampening the extent of the increase in the interest rate on the fall of I and subsequently on the fall of Y. BlCh5

A monetary contraction M’s i Ms i IS LM i Md Ye Y M/P BlCh5

g. Monetary expansion: M/P increases to 1840 Problem #5 cont. g. Monetary expansion: M/P increases to 1840 Same IS curve: Y = 1100 - 2000i New LM curve: 2Y - 8000i = 1840 i = Y/4000 - 1840/8000 i = Y/4000 - .23 Solve the IS-LM system: Y = 1100 - 2000(Y/4000 - .23) Y = 1100 - .5Y - 460 1.5 Y = 1560 so Y = 1040 BlCh5

A monetary expansion reduces i and increases Y Replace in LM: i = 1040/4000 - .23 so i = .03 or 3% Solve for C and I C = 410 and I = 380 A monetary expansion reduces i and increases Y Thus C (function of Y) increases and I (function of Y and of i) increases unambiguously. BlCh5

Policy Mix 1 To maximize the expansionary (or contractionary) impact on the economy, use both expansionary monetary and expansionary fiscal policy (or both contractionary). LM i IS Y Rational: BlCh5

Policy Mix 2 To dampen the inflationary impact of an expansionary fiscal policy, use at the same time contractionary monetary policy. i LM IS Y Rational: BlCh5