Chapter 17A Online Appendix The IS-LM Model and the DD-AA Model

Preview IS-LM model Effects of permanent and temporary Increases in the money supply Fiscal expansions

IS-LM Model The DD-AA model assumed that investment expenditure is determined by exogenous business decisions. In reality, the amount of investment expenditure depends on the interest rate. Investment projects use saved or borrowed funds, and the relevant interest rate represents the (real) cost of spending or borrowing those funds. A higher interest rate means less investment expenditure. The IS-LM model predicts that investment expenditure is inversely related to the relevant interest rate.

IS-LM Model (cont.) The IS-LM model also allows for consumption expenditure and expenditure on imports to depend on the interest rate. A higher interest rate makes saving more attractive and consumption expenditure (on domestic and foreign products) less attractive. However, the effect of the interest rate is much larger on investment expenditure than it is on consumption expenditure and imports.

D = C(Y – T, R-e ) + I(R-e)+ G + CA(EP*/P, Y – T, R-e) IS-LM Model (cont.) The IS-LM model expresses aggregate demand as: D = C(Y – T, R-e ) + I(R-e)+ G + CA(EP*/P, Y – T, R-e) Or more simply: D = D(EP*/P, Y – T, R-e, G) Consumption as a function of disposable income and the real interest rate R-πe Investment as a function of the real interest rate R-πe Government purchases are exogenous Current account as a function of the real exchange rate, disposable income and the real interest rate R-πe

IS-LM Model (cont.) Instead of relating exchange rates and output, the IS-LM relates interest rates and output. In equilibrium, aggregate output = aggregate demand Y = D(EP*/P, Y – T, R-e, G) In equilibrium, interest parity holds R = R* + (Ee –E)/E E(1+R) = ER* + Ee E(1+R–R*) = Ee E = Ee/(1+R–R*)

IS-LM Model (cont.) Y = D(EeP*/P(1+R–R*), Y – T, R-e, G) This equation describes the IS curve: combinations of interest rates and output such that aggregate demand equals aggregate output, given values of exogenous variables Ee, P*, P, R*, T, e, and G. Lower interest rates increase investment demand (and consumption and import demand), leading to higher aggregate demand and higher aggregate output in equilibrium. The IS curve slopes down.

IS-LM Model (cont.) In equilibrium, the quantity of real monetary assets supplied matches the quantity of real monetary assets demanded: Ms/P = L(R,Y) This equation describes the LM curve: combinations of interest rates and output such that the money market is in equilibrium, given values of exogenous values P and Ms. Higher income is predicted to cause higher demand of real monetary assets and higher interest rates in the money market. The LM curve slopes up.

Fig. 17A-1: Short-Run Equilibrium in the IS-LM Model

Permanent and Temporary Increases in the Money Supply The IS-LM model can be used to analyze the effects of monetary and fiscal policies. A temporary increase in the money supply shifts LM to the right, lowering the interest rate and expanding output. A permanent increase in the money supply, however, shifts LM to the right but also shifts IS to the right, since in an open economy that schedule depends on Ee, which now rises.

Permanent and Temporary Increases in the Money Supply (cont.) The right-hand side of Figure 2 shows these shifts. At the new short-run equilibrium following a permanent increase in the money supply (point 2), output and the interest rate are higher than at the short-run equilibrium (point 3) following an equal temporary increase. The nominal interest rate can even be higher at point 2 than at point 1.

Permanent and Temporary Increases in the Money Supply (cont.) The left-hand side of Figure 17A-2 shows how the monetary changes affect the exchange rate. The interest rate R2 following a permanent increase in the money supply implies foreign exchange market equilibrium at point 2’, since the accompanying rise in Ee shifts the curve that measures the expected domestic currency return on foreign deposits. That curve does not shift if the money supply increase is temporary, so the equilibrium interest rate R3 that results in this case leads to foreign exchange equilibrium at point 3’.

Fig. 17A-2: Effects of Permanent and Temporary Increases in the Money Supply in the IS-LM Model

Permanent and Temporary Fiscal Expansions A temporary increase in government spending shifts IS to the right but has no effect on LM. The new short-run equilibrium at point 2 in Figure 17A-3 shows a rise in output and a rise in the nominal interest rate, while the foreign exchange market equilibrium at point 2’ indicates a temporary currency appreciation.

Permanent and Temporary Fiscal Expansions (cont.) A permanent increase in government spending causes a fall in the long-run equilibrium exchange rate and thus a fall in Ee. The IS curve does not shift out, unlike for a temporary policy. It does not shift at all: a permanent fiscal expansion has no effect on output or the home interest rate.

Permanent and Temporary Fiscal Expansions (cont.) The reason why permanent fiscal policy moves are weaker than transitory ones can be seen in the figure’s left-hand side (point 3’). The accompanying change in exchange rate expectations generates a sharper currency appreciation and thus, through the response of net exports, a complete “crowding out” effect on aggregate demand.

Fig. 17A-3: Effects of Permanent and Temporary Fiscal Expansions in the IS-LM Model

Summary The IS-LM model compares interest rates with output. The IS curve shows combinations of interest rates and output where aggregate demand = aggregate output. The LM curve shows combinations of interest rates and output where the money market is in equilibrium. The IS-LM model can be used with the model of the foreign exchange markets to compare output, interest rates, and exchange rates.