Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 24 The ISLM World

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Learning Objectives Identify the shift and slope determinants of the LM curve Identity the shift and slope determinants of the IS curve Understand how combining the IS and LM curves determines an equilibrium level of real GDP and interest rates Explain how ISLM analysis is connected to the aggregate demand curve

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Introduction ISLM analysis—a more complex model of GDP determination –Shows how monetary and fiscal policy interact –Shows what determines the relative multiplier effects of each –Provides a partial integration of the classical and Keynesian systems into one conceptual framework –Demonstrates some of the fundamental features distinguishing classical and Keynesian outlooks

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Introduction (Cont.) Initially assume a fixed price level—concerned with the level of real GDP Followed by an analysis of the implications of flexible wages and prices Ultimately the discussion shows how the ISLM model collapses into an aggregate demand schedule

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The LM Curve Classical economists stressed the transactions demand for money Keynes had a more complex view of the transactions demand –Since transactions demand increases with income, the rate of interest rises as income rises –Not only does the interest rate help determine income (classical view), income helps determine the interest rate (Keynesian)

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The LM Curve (Cont.) Keynesian View (Cont.) –Causation runs both ways—from interest rate to income and from income to the interest rate –A reformulation of the model permits determination of both interest rates and income

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The LM Curve (Cont.) Figure 24.1 –Shows three alternative money-demand functions, each associated with a different level of economic activity –Each level of GDP has its own liquidity-preference function since more money is demanded for transaction balances at higher income levels –Therefore, the demand for money is really a function of two variables—income and interest rate

Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE 24.1 How to derive the LM curve: At higher levels of income, the demand for money rises and so do interest rates.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The LM Curve (Cont.) Figure 24.1 (Cont.) –The equilibrium condition (money demanded = money supplied) no longer provides a single interest rate –There is a combination of income (Y) and interest rate (r) that satisfies this equilibrium condition, when the money supply is fixed

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The LM Curve (Cont.) Figure 24.2 –A plot of the relationship between Y and r that satisfies equilibrium conditions in the money market –Interest rate is on the vertical axis and income on the horizontal axis –This relationship is labeled the LM curve since is it the locus of combinations of Y and r that satisfy the equilibrium condition –At different interest rates, shows what the resulting income would have to be to make demand for money equal to (fixed) supply

Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE 24.2 The LM curve.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The LM Curve (Cont.) Figure 24.2 (Cont.) –Tells what the resulting interest rate would have to be at different income levels to insure demand and supply of money were equal –At higher income levels, more transaction money is desired, so the interest rate must be higher to reduce the demand to maintain equilibrium with a fixed supply –However, this relationship by itself does not determine the actual value of Y and r—need another relationship to interact with the LM curve

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Slope of the LM Curve Figure 24.3 –Explores the slope of the LM curve –Assume point A is the initial equilibrium point and income increases from Y 1 to Y 2 –At the original interest rate r 1, the demand for money is too great and interest rates must increase to r 2 to restore equilibrium

Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE 24.3 The slope of the LM curve.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Slope of the LM Curve (Cont.) Figure 24.3 (Cont.) –The actual slope of the LM curve is determined by two factors The size of the gap between money demand and supply at point C—the larger the distance, the greater the required increase in r and steeper the slope The interest-sensitivity of money demanded—the greater the interest-sensitivity the steeper the slope

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Slope of the LM Curve (Cont.) Monetary Policy and the LM curve –Figure 24.4 –An increase in the money supply causes the LM curve to shift to the right –Therefore, the Federal Reserve can increase the potential equilibrium level of GDP associated with a given interest rate (point a to point b) –However a change in income is not the only way an increase in the money supply can be absorbed into the economy

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Figure 24.4 An increase in the money supply shifts the LM curve to the right

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Slope of the LM Curve (Cont.) Monetary Policy and the LM curve –Since the supply of money exceeds the demand at the old rate, the interest rate may fall (point a to point c) to increase the demand –Therefore, it is possible to increase Y or decrease r, or some combination of the two

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The IS Curve According to classical economists, interest rates are determined by the interaction between desired saving and investment Figure 24.5 and 24.6 demonstrate the inverse (negative) relationship between the level of interest and the level of investment Figure 24.6 summarizes the inverse relationship between interest rate determined in the goods market and the level of income

Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE 24.5 How to derive the IS curve: At lower rates of interest the level of investment is higher,and so is the level of income.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE 24.5 How to derive the IS curve: At lower rates of interest the level of investment is higher,and so is the level of income. (Cont.)

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Figure 24.6 The investment-demand function.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The IS Curve (Cont.) IS curve (Figure 24.7)—locus of points satisfying the investment-equals-savings equilibrium condition with interest (r) on the vertical and income (Y) on the horizontal –At lower interest rates, there is more investment, so income must be higher to increase the amount of savings –At higher income levels, savings is higher, so the interest rate must be lowered to encourage the additional savings

Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE 24.7 The IS curve and its slope.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Slope of the IS Curve The slope of the IS curve is determined by two factors—the sensitivity of the investment function (I versus r) and the marginal propensity to save (1 – b) –A highly interest-sensitive investment function will result in a flat IS curve –A low marginal propensity to save also implies a flat IS curve

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Slope of the IS Curve (Cont.) The position of the IS curve is altered by any change in autonomous spending –Government spending or taxation –Private investment that is independent of the rate of interest, but depends on the expectations of entrepreneurs

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Slope of the IS Curve (Cont.) Figure 24.8 –Shows the effect of an increase in government spending on position of IS curve [IS(G 1 ) to IS(G 2 )] –This causes each of the total-expenditure functions to shift upward, producing a higher level of Y for each interest rate –Starting at point a, shifting the IS curve upward can result in different outcomes An increase in income (point a to point b) An increase in interest rates (point a to point c) Some combination of the two—higher income and higher interest rates

Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE 24.8 An increase in government spending shifts the IS curve to the right

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Slope of the IS Curve (Cont.) Figure 24.8 (Cont.) –Keynesians argue that an increase in government spending will significantly increase GDP— movement toward point b –However, classical economists feel increased government spending would result in increased interest with no increase in GDP—movement toward point c

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Determination of Income/Interest: IS and LM Together Figure 24.9 –This represents a simultaneous plot of the LM curve (given a fixed supply of money) and the IS curve (given a level of autonomous spending) –The intersection of the two curves (point E) represents the equilibrium level of income (Y) and interest (r) –At any other point on the graph, equilibrium conditions are violated and dynamic forces will move income and interest rate toward point E.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE 24.9 The simultaneous determination of income and interest (fantastic!).

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Determination of Income/Interest: IS and LM Together (Cont.) Figure 24.9 (Cont.) –Point E is a stable equilibrium--as long as nothing shifts the IS or LM curves, there is no tendency for Y or r to change –However, this is nothing sacred about income Y E —it may or may not be a full employment level of output –This opens up the possibility of using monetary or fiscal policy to shift one or both of the curve to move the economy to the full employment level

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Monetary and Fiscal Policy Monetary Policy –Figure 24.10—Shifting the LM curve to the right along a stable IS curve will simultaneously increase Y and decrease r (Y to Y 1 and r to r 1 ) –Figure Contrasts the effects of the LM curve interacting with a steep IS curve and a flat IS curve A flat IS curve can be due to a highly interest-sensitive investment function Flat IS curve—impact of monetary policy is effective on increasing GDP, relatively smaller effect on interest

Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE An expansionary monetary policy.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE Monetary policy is more effective the flatter the IS curve.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Monetary and Fiscal Policy (Cont.) Monetary Policy (Cont.) –Figure Contrasts the effects monetary policy with a steep LM curve versus a flat LM curve interacting with a given IS curve If the demand for money is rather insensitive to changes in the rate of interest, the LM curve is steeper Steep LM curve—larger the decline in the rate of interest and the greater the increase in GDP

Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE Monetary policy is more effective the steeper the LM curve.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Monetary and Fiscal Policy (Cont.) Fiscal Policy –Figure Shifting the IS curve upward will simultaneously increase income and interest rates (Y to Y 1 and r to r 1 ) In previous chapters, the multiplier effect on GDP resulting from an increase of government spending ignored the impact of increasing interest rates—shown by a movement from Y to Y n

Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE An expansionary fiscal policy.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Monetary and Fiscal Policy (Cont.) Fiscal Policy (Cont.) –Figure (Cont.) Crowding-out effect –Increased government borrowing to finance the spending will increase interest rates –Higher interest rates will reduce investment spending which will tend to reduce the increase in GDP –Therefore, the net effect of increased government spending will be diminished by the reduction in investment spending

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Monetary and Fiscal Policy (Cont.) Fiscal Policy (Cont.) –Figure Shows two LM curves—the flatter the curve, the smaller the interest-sensitivity of liquidity preferences— interacting with a given shift of the IS curve The flatter the LM curve, the less the increase in interest rates and the greater the increase in GDP—smaller crowding-out effect

Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE Fiscal policy is more effective the flatter the LM curve.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Monetary and Fiscal Policy (Cont.) Fiscal Policy (Cont.) –Figure Shows two IS curves—the flatter the curve, the greater the interest-sensitivity of the investment function—interacting with a fixed LM curve The flatter the IS curve, the less the increase in interest rates and the greater the increase in GDP—smaller crowding-out effect

Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE Fiscal policy is more effective the steeper the IS curve.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved What about Velocity While it appears the Keynesian analysis does not utilize the concept of velocity, it is actually embedded in the LM function Given a fixed money supply, as one moves up along an LM function, the income velocity of money is necessarily going up since Y is increasing

Copyright © 2009 Pearson Addison-Wesley. All rights reserved What about Velocity (Cont.) Figure –Rightward shifts of the IS curve caused by increased government spending results in raising GDP through increased velocity –This occurs since the demand for money is sensitive to the rate of interest and the increased interest induces public to hold less speculative balances, freeing more cash to be used for transactions

Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE When the IS curve shifts, both income and velocity rise.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved What about Velocity (Cont.) Figure –If the demand for money were totally insensitive to the interest, velocity would be constant and GDP would not be affected by shifts in autonomous spending –This results in a perfectly vertical LM curve at that level of GDP

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Figure When the LM curve is vertical, shifts in the IS curve raise neither income nor velocity.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved What about Velocity (Cont.) Figure (Cont.) –In this case, increased government spending results only in higher interest rates and no increase in GDP –Complete crowding-out—the increase in interest reduces investment spending by the same amount as the increase in government spending

Copyright © 2009 Pearson Addison-Wesley. All rights reserved What about Velocity (Cont.) ISLM curves—integration of classical and Keynesian economics –Keynesian theory—the rate of interest is determined by the supply of and demand for money—LM curve –Classical theory—the rate of interest is determined exclusively by savings and investment—IS curve

Copyright © 2009 Pearson Addison-Wesley. All rights reserved When Will Full Employment Prevail? The question remains—why do not variations in interest automatically result in full employment in Keynesian system Nothing in the analysis will permit the automatic shifting of the IS or LM curves without additional autonomous spending The Keynesian analysis states that the only way to push the economy toward full employment is to increase economic activity through additional government spending

Copyright © 2009 Pearson Addison-Wesley. All rights reserved When Will Full Employment Prevail? (Cont.) Classical adjustment with ISLM curves (Figure 24.18) –If prices are permitted to vary, the ISLM analysis will permit the automatic adjustment –Under conditions of less than full employment, both prices and wages would fall –Since real income would remain the same, this suggests there would be no automatic change in real factors

Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE The classical position: Lower prices shift the LM curve to the right and automatically produce full employment.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved When Will Full Employment Prevail? (Cont.) Classical adjustment with ISLM curves (Cont.) – However, falling prices would increase the real value of the supply of money –This in turn would tend to shift the LM curve to the right, lowering interest rates and increasing desired investment until full employment was restored

Copyright © 2009 Pearson Addison-Wesley. All rights reserved When Will Full Employment Prevail? (Cont.) Keynesian attack on the above: –Inflexibility of prices and wages would not permit the adjustment –Liquidity trap (Figure 24.19) The LM curve is perfectly horizontal Increase in the money supply (though lowering of prices) would not lower the interest rate No automatic increase in investment/output and employment would remain below full employment levels

Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE An extreme Keynesian position: A liquidity trap.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved When Will Full Employment Prevail? (Cont.) Keynesian attack on the above: (Cont.) –Interest-insensitive investment function (Figure 24.20) The IS curve is very steep Therefore, declining prices and the reduction in interest rates will not be able to raise investment sufficiently to generate full employment levels

Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE Another extreme Keynesian position: Investment unresponsive to the interest rate.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved When Will Full Employment Prevail? (Cont.) Wealth effect of lowering prices (classical counter) –Falling prices increase both liquidity and wealth –Increased wealth will raise desired consumption function at every level of income –This acts like any autonomous increase in spending and will automatically shift the IS curve to the right toward full employment

Copyright © 2009 Pearson Addison-Wesley. All rights reserved ISLM and Aggregate Demand The aggregate demand curve relates the price level to demand for real output The ISLM analysis focuses on the relation between interest and demand for real output Therefore, it is relatively straightforward to generate a complete aggregate demand schedule from the ISLM model

Copyright © 2009 Pearson Addison-Wesley. All rights reserved ISLM and Aggregate Demand (Cont.) Figure –Different price levels are associated with a family of LM curves –Lowering the price levels will cause the LM curves to shift to the right –The equilibrium level of output (Y) of the different LM curves and a fixed IS curve will trace out an aggregate demand that relates prices to output

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Figure Deriving aggregate demand from ISLM.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Figure Deriving aggregate demand from ISLM. (Cont.)

Copyright © 2009 Pearson Addison-Wesley. All rights reserved ISLM and Aggregate Demand (Cont.) Figure (Cont.) –Additionally, a shifting of the IS curve, coupled with different LM curves generated by different price levels, will trace out a different aggregate demand curve –Less obvious, but also true, an increase in the stock of money shifts the aggregate demand to the right

Copyright © 2009 Pearson Addison-Wesley. All rights reserved TABLE 24.1 A Summary of Monetary and Fiscal Policy Effectiveness

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Appendix THE SIMPLE ALGEBRA OF INCOME DETERMINATION

Copyright © 2009 Pearson Addison-Wesley. All rights reserved APPENDIX—THE SIMPLE ALGEBRA OF INCOME DETERMINATION Much of ISLM analysis can be summarized in equation form The economy is divided into two sectors –The goods or product markets, comprising the demand for goods and services –The monetary sector, comprising the demand for and supply of money

Copyright © 2009 Pearson Addison-Wesley. All rights reserved APPENDIX—THE SIMPLE ALGEBRA OF INCOME DETERMINATION (Cont.) The Model –The product market can be described by four functional relationships (behavior equations) and one equilibrium condition (an identity) All functional relationships are assumed to be linear The functional relationships (numbers shown in the textbook) –(1) Consumption (C) function –(2) Investment (I) function –(3) Tax (T) function –(4) government spending (G) The equilibrium condition –(5) C + I + G + Y or S + T = I + G

Copyright © 2009 Pearson Addison-Wesley. All rights reserved APPENDIX—THE SIMPLE ALGEBRA OF INCOME DETERMINATION (Cont.) –The monetary sector of the economy consists of two functional relationships and one equilibrium condition Functional relationships –(6) Liquidity preference (L) or demand-for-money function –(7) Money supply (M) Equilibrium condition –(8) L = M

Copyright © 2009 Pearson Addison-Wesley. All rights reserved APPENDIX—THE SIMPLE ALGEBRA OF INCOME DETERMINATION (Cont.) –The IS and LM functions By solving equations (1) through (5), we find the IS function: equation (9) By solving equations (6) through (8), we find the LM function: equation (10) –Equilibrium Income and Interest By solving equations (9) and (10) simultaneously, we obtain: – equilibrium income (Y): equation (11) –interest rate (r): equation (12) –Multiplier Effects on Income and Interest Rates From equation (11) we can derive the multiplier effects on income: equations (13) through (15) From equation (12) we can derive the multiplier effects on the interest rate: equations (16) through (18)