Chapter 4 -- The IS-LM Model zFundamental inflexibility assumptions: W -- inflexible P -- inflexible i -- flexible zOverriding theme -- The interest rate changes as a result of monetary policy (money supply) as well as other factors.

The IS Curve zRe-translation of Simple Keynesian model at equilibrium (Investment = Saving). zA plot of equilibrium output for various interest rates within the market for goods and services.

Properties of the IS Curve zDownward sloping, i   C , I   Y*  zShift variables consist of the shift variables of the E P curve, except for the nominal interest rate (i).

Shifting the IS Curve zIncreases in autonomous expenditure which shift the E P curve upward, simultaneously shift the IS curve rightward. zDecreases in autonomous expenditure which shift the E P curve downward, simultaneously shift the IS curve leftward.

Steepness or Flatness of the IS Curve zThe steepness or flatness of the IS curve describes the elasticity or responsiveness of C and I to the nominal interest rate. -- Steep IS curve: inelastic. -- Flat IS curve: elastic.

Considering Additional Behavior (Curve #2) zExtra behavior -- decisions to hold money and financial assets. zThe Demand for Money -- The decision of how much of total wealth should be held as money (I.e. currency and checkable deposits).

Fundamental Aspects -- The Demand for Money zGroup all assets into two categories -- money and “bonds”. zAdvantage of holding money -- convenience for making desired transactions. zDisadvantage of holding money -- interest that could be earned by holding bonds instead.

More Fundamentals: The Demand for Money zMajor advantage of holding money implies that we demand money in real units. zThe Demand for Money (L) -- liquidity preference. zFor a given level of real wealth, the demand for money covers the entire financial asset holding decision (Walras Law).

The Demand for Money in Real Terms (L) -- Causes zOutput or Income (Y) Y   L  zThe interest rate (i) i   L  zFinancial Innovation (FI) FI   L 

The Supply of Real Money (M s /P) -- Causes zThe Nominal Money Supply (M S ) -- the Federal Reserve’s variable for monetary policy. M S   (M S /P)  zThe (Inflexible) Price Level (P) P   (M S /P) 

The LM Curve zDepicts equilibrium in the money market (L = M), as well as the Bond Market (by Walras Law). zA plot of the equilibrium interest rate for various levels of output or income versus the interest rate, within the money market for a given level of the nominal money supply.

Properties of the LM Curve zUpward sloping, Y   L   i*  zShift variables consist of the shift variables of the money demand and supply curves (except for Y).

Shifting the LM Curve zIncreases in the real money supply (M S  or P  ) shift the LM curve rightward. zDecreases in the real money supply (M S  or P  ) shift the LM curve leftward.

Steepness or Flatness of the LM Curve zThe steepness or flatness of the LM curve describes the elasticity or responsiveness of money demand (L) to the nominal interest rate. -- Steep LM curve: inelastic. -- Flat LM curve: elastic.

Economic Policy: IS-LM Model zEquilibrium output (Y*) takes place where the IS and LM curves intersect (equilibrium interest rate, i*, as well). zKeynesian property of model  Y* < Y N, (sluggish economy) Y* > Y N, (accelerating inflation) Y* = Y N (desired state)

Types of Policy: IS-LM Model zFiscal Policy – Federal givernment changes G 0, T 0, t, or other components of autonomous goods and services expenditure  Shift the IS curve. zMonetary Policy – Federal Reserve changes the nominal money supply (M S )  Shift the LM curve.

Expansionary and Contractionary Policy zExpansionary (Y* < Y N ) -- shifts the appropriate curve rightward. zContractionary (Y > Y N ) -- shifts the appropriate curve leftward.

Policy Effectiveness zAn effective policy is one that obtains a large output response for a given change -- zPolicy effectiveness depends upon the steepness or flatness of the IS and LM curves.