Goods and Financial Markets: The IS-LM Model

The Goods Market and the IS Relation 5-1 Equilibrium in the goods market exists when production, Y, is equal to the demand for goods, Z. In the simple model developed in chapter 3, the interest rate did not affect the demand for goods. The equilibrium condition was given by:

Investment, Sales, and the Interest Rate In this chapter, we capture the effects of two factors affecting investment: The level of sales (+) The interest rate (-)

The Determination of Output Taking into account the investment relation above, the equilibrium condition in the goods market becomes:

The Determination of Output Equilibrium in the Goods Market The demand for goods is an increasing function of output. Equilibrium requires that the demand for goods be equal to output. When the ZZ line is flatter than the 45-degree line, an increase in output leads to a less than one-for-one increase in demand. Note: The ZZ line is flatter than the 45° line only if increases in consumption and investment do not exceed the corresponding increase in output.

Deriving the IS Curve The Effects of an Increase in the Interest Rate on Output An increase in the interest rate decreases the demand for goods at any level of output. When the ZZ line is flatter than the 45-degree line, an increase in output leads to a less than one-for-one increase in demand.

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.

Shifts of the IS Curve Shifts of the IS Curve An increase in taxes shifts the IS curve to the left.

Financial Markets and the LM Relation 5-2 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: From chapter 2, recall that Nominal GDP = Real GDP multiplied by the GDP deflator: Equivalently:

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.

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

Putting the IS and the LM Relations Together 5-3 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.

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 5-4 The combination of monetary and fiscal polices is known as the monetary-fiscal policy mix, or simply, the policy mix. Table 5-1 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 Table 5-2 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

How does the IS-LM Model Fit the Facts? 5-5 The Empirical Effects of an Increase in the Federal Funds Rate In the short run, an increase in the federal funds rate leads to a decrease in output and to an increase in unemployment, but has little effect on the price level. The two dotted lines and the tinted space between them gives us a confidence band, a band within which the true value of the effect lies with 60% probability.

Key Terms IS curve, LM curve, fiscal contraction, fiscal consolidation, fiscal expansion, monetary expansion, monetary contraction, tightening, monetary-fiscal policy mix, or policy mix, confidence band,