© Stephen Hall, Imperial College LondonPage 1 Economic Environment Lecture 5 Joint Honours 2003/4 Professor Stephen Hall The Business School Imperial College London

© Stephen Hall, Imperial College LondonPage 2 Revision Money demand is: positively related to income; the more income people have, the more money they want to hold. negatively related to the interest rate; because the higher is the interest rate, the more people would prefer to save rather than hold money.

© Stephen Hall, Imperial College LondonPage 3 Money Supply & Demand For a given level of income, there is an interest rate, which will induce households and businesses to demand exactly the amount of money, which the government has chosen to supply. We will call this the “money market equilibrium”, and depict it as follows: Money demand Money supply i moneyM ieie

© Stephen Hall, Imperial College LondonPage 4 The LM Curve The previous diagram shows the equilibrium interest rate for a given level of income “Y”. (Note the functional notation on the money demand curve). But we do not yet know what Y is! Remember, Y e is what we are trying to find.

© Stephen Hall, Imperial College LondonPage 5 The LM Curve According to our first assumption, money demand will increase (i.e. visually shift rightward) as income increases. As this happens, the equilibrium interest rate “i e “ will also increase Money supply i moneyM i1i1 M d (y 0 } M d (Y 1 ) M d (Y 2 ) i0i0 i2i2

© Stephen Hall, Imperial College LondonPage 6 The LM Curve Therefore, all we really have is a set of interest rate/income combinations that will serve to clear the money market. If we plot the i, Y combinations explicitly, we have what is known as the LM-Curve. i Y LM-curve Y 0 Y 1 Y 2 i2i1i0i2i1i0

© Stephen Hall, Imperial College LondonPage 7 The LM Curve r r Income Real money balances L0L0 LL 0 r0r0 r0r0 Y0Y0 At income Y 0, money demand is at LL 0 and equilibrium in the money market requires an interest rate of r 0. r1r1 Y1Y1 r1r1 LL 1 At Y 1, money demand is at LL 1, and equilibrium is at r 1. LM The LM schedule traces out the combinations of real income and interest rate in which the money market is in equilibrium.

© Stephen Hall, Imperial College LondonPage 8 This Week The LM curve shows combinations of Y and i which give equilibrium in the money market The IS curve shows combinations of Y and i which give equilibrium in the goods market This week we put the two together.

© Stephen Hall, Imperial College LondonPage 9 IS-LM Equilibrium We looked first at the commodities market, and then at the money market. Once the interest rate was introduced as a variable, we were unable to solve for the exact equilibrium output level (or equilibrium interest rate) for either market. Instead, we obtained the following two relationships: The IS-curve: Shows combinations of interest rate and output that put the commodities market in equilibrium. The LM-curve: Shows combinations of interest rate and output that put the money market in equilibrium. When viewed as mathematical equalities, the IS-LM curves are simply two equations in two unknowns (i e and Y e ). Therefore, they can be solved simultaneously.

© Stephen Hall, Imperial College LondonPage 10 IS-LM Equilibrium Putting the two curves together: Clearly, the unique equilibrium values for Y and i are found at the intersection of the two curves. (And, once these equilibrium values are known, the values for all other variables like C, I, T, etc. can be found as well!). This is best illustrated by example. Interest Rate ieie IS-curve LM-curve YeYe Output

© Stephen Hall, Imperial College LondonPage 11 Shifting IS and LM schedules The position of the IS schedule depends upon: –anything (other than interest rates) that shifts aggregate demand: e.g. autonomous investment autonomous consumption government spending The position of the LM schedule depends upon –money supply –(the price level)

© Stephen Hall, Imperial College LondonPage 12 Fiscal policy in the IS-LM model Income r IS 0 LM Y0Y0 r0r0 Y 0, r 0 represents the initial equilibrium. IS 1 A bond-financed increase in government spending shifts the IS schedule to IS 1. r1r1 Y1Y1 Equilibrium is now at r 1, Y 1. Some private spending has been crowded out by the increase in the rate of interest.

© Stephen Hall, Imperial College LondonPage 13 Monetary policy in the IS-LM model Income r IS 0 LM 0 Y0Y0 r0r0 Y 0, r 0 represents the initial equilibrium. LM 1 An increase in money supply shifts the LM schedule to the right. Y1Y1 r1r1 Equilibrium is now at r 1, Y 1.

© Stephen Hall, Imperial College LondonPage 14 IS-LM Equilibrium Example 3 IS-LM The following example is simply a continuation of Example 3 from the commodity market, and Example 3 from the money market. Recall from these examples: C = 300 – 30i Yd T = Y (Solves as C = 220 – 30i Y) I = 250 – 20i G = 480 Summing C + I + G gives us the demand curve: AD  950 – 50i Y

© Stephen Hall, Imperial College LondonPage 15 IS-LM Equilibrium Example 3 IS-LM And, setting demand equal to supply Y gives us the equilibrium: Y  950 – 50i Y Which can be re-written as the IS-curve: (IS-Curve) Y = 2,375 – 125i From the money market, we have Ms = 475 Md = Y - 70i Which, when equated, gives us the money market equilibrium condition (LM-curve) Y = i.

© Stephen Hall, Imperial College LondonPage 16 IS-LM Equilibrium Example 3 IS-LM The IS- and LM-curves are: (IS-Curve) Y = 2,375 – 125i. (LM-Curve) Y = i. Setting the two equal to each other gives: 2,375 – 125i = i, or i e = 7(%) Inserting this equilibrium value for the interest rate back into the LM-curve (or the IS-curve) gives:Y e = 1,500

© Stephen Hall, Imperial College LondonPage 17 IS-LM Equilibrium Example 3 IS-LM Graphically, In turn, all the other equilibrium values can be determined T = (1,500) = 475 Budget deficit = G - T = = PSBR of 5 Yd = (1,500) = 1,025 C = (7) (1,025) = 910 I = (7) = 110 Interest Rate IS-curve LM-curve Y e =1500 Output 7%

© Stephen Hall, Imperial College LondonPage 18 And, to verify, Md = (1,500) - 70(7) = 475 (same as the Ms). Also, recall that Y = C + S + T )or equivalently, S = Y - C – T), so that saving S = 1, = 115. Essentially, of the 115 being saved, 110 is going to firms for investment, and the other 5 is being borrowed by the government.

© Stephen Hall, Imperial College LondonPage 19 Expansionary Monetary and Fiscal Policies Using the IS-LM framework we are able to solve for the equilibrium, most importantly of Y. These values depend explicitly on decisions by government; namely on fiscal policy and on monetary policy. From the IS-LM diagram, it is clear that equilibrium output, Y e, will increase when either the IS-curve or the LM-curve shifts rightward. Therefore, any government fiscal policy which serves to shift the IS-curve rightward, or monetary policy which serves to shift the LM-curve rightward, will be expansionary, i.e. cause Ye to increase and the economy to grow.

© Stephen Hall, Imperial College LondonPage 20 Expansionary Monetary and Fiscal Policies Expansionary fiscal policies include: Increasing government expenditure G or decreasing personal taxation T. Expansionary monetary policies include: Increasing the money supply Ms or (equivalently) lowering the interest rate I. So, the question naturally arises: What is the most effective way for the government to induce the economy to grow?

© Stephen Hall, Imperial College LondonPage 21 Expansionary Monetary and Fiscal Policies Before looking at the Monetarist/Keynesian debate on this issue, it is necessary to remind ourselves that the model we’re working with is a static, short-term model. This model will enable us to understand the policy debate, but (as we’ll see later) it sheds little light on what are appropriate long-term strategies.

© Stephen Hall, Imperial College LondonPage 22 Exercise 1 DO EXERCISE 1 This exercise requires that you solve for the equilibrium values associated with Examples 4a to 4d from note packet a. These should verify the claims made above.

© Stephen Hall, Imperial College LondonPage 23 Inflation is... Inflation is a rise in the average price of goods over time One of the first acts of the Labour government in 1997 was to make the Bank of England independent –with a mandate to achieve low inflation.

© Stephen Hall, Imperial College LondonPage 24 Some questions about inflation Why is inflation bad? –Inflation does have bad effects, but some popular criticisms are based on spurious reasoning What are the causes of inflation? What can be done about it?

© Stephen Hall, Imperial College LondonPage 25 Inflation in the UK, Source: Economic Trends Annual Supplement, Labour Market Trends

© Stephen Hall, Imperial College LondonPage 26 The Monetarist v. Keynesian Debate The first models we introduced (in the commodity market) did not include interest rates or prices of any kind, and equilibrium output was entirely demand- determined. In these simple models (Models 1 and 2), the government could increase output either by cutting taxes or by increasing its own expenditure.

© Stephen Hall, Imperial College LondonPage 27 The Monetarist v. Keynesian Debate When interest rates and the money market were included (Model and Example 3), however, we introduced a third way of inducing economic growth; by increasing the money supply (or, identically, cutting the interest rate). An additional implication of this more complicated model is that fiscal policies are less effective than we had previously thought: As the government spends more, the interest rate rises and private investment and consumption fall; thus partially offsetting the expansionary effects of the government’s policy. So which of these policies - fiscal or monetary - is best?

© Stephen Hall, Imperial College LondonPage 28 The Monetarist v. Keynesian Debate Essentially, the answer is an empirical one. Theory doesn’t really tell us. Rather, it will depend upon how strongly households and firms respond to changes in the interest rate and income.

© Stephen Hall, Imperial College LondonPage 29 The Monetarist v. Keynesian Debate Essentially, Monetarists believe that (1) money demand is not very responsive to interest rates. Graphically, this means that the money demand curve is very steep. Monetarists also believe however, that (2) investment, in particular, is very responsive to interest rate changes. this makes the IS curve relatively flat. According to the monetarist assumptions, changing the money supply would have a great effect on output, but fiscal policy would be relatively ineffective. Ironically, monetarists promote a cautious, stable monetary policy rather than an activist one, largely because of the practical and political difficulties of conducting an appropriate monetary policy. In any event, in the longer term any positive effects of expansionary monetary policy are offset by higher prices, which cause demand for money to increase, the LM curve to shift back, and output to return roughly to its original level. Thus, once the picture is completed, neither policy is very effective, (according to monetarists!).

© Stephen Hall, Imperial College LondonPage 30 Monetarism Monetarism has its roots in the old “quantity theory” of money, which is embodies in the equation: money x velocity = price x real output. In words: the amount of physical money, multiplied by the number of times each coin or note is circulated (i.e., its velocity) must equal the total amount of money spent in the economy, which is simply price (per unit of output) times the amount of output.

© Stephen Hall, Imperial College LondonPage 31 Monetarists do not assume, as do Keynesians, that supply can adjust to meet any increase in demand. Rather, they assume that markets clear, and therefore that supply (i.e. output Y) is already at its full-employment level. Output is thus more or less fixed irrespective of government policy. Monetarists also assume that monetary velocity is relatively constant. If so, then the quantity theory equation above implies that increasing the money supply affects mostly the price level (proportionately) and does little to affect real output.

© Stephen Hall, Imperial College LondonPage 32 Monetarism Thus, the completed IS-LM model, with price changes added in (see below), is compatible with the old quantity theory of money, in that both imply no active role for government in stimulating economic activity. (Indeed, this is why noted monetarists generally believe in a laissez-faire government economic policy).

© Stephen Hall, Imperial College LondonPage 33 Monetarist v. Keynesian: Graphically With respect to expansionary fiscal policy, the Keynesian v. Monetarist debate can be illustrated as follows. Monetarist monetary expansion (before price increases): M s M s’ iiii M s M s1 i Y LM LM 1 M d1 IS

© Stephen Hall, Imperial College LondonPage 34 A Keynesian Monetary Expansion M iiii M s M s1 i Y LM M d1 i IS

© Stephen Hall, Imperial College LondonPage 35 Exercise 2 DO EXERCISE 2 Exercise 2 shows the effectiveness of various fiscal and monetary policies under both the monetarist and Keynesian assumptions.

© Stephen Hall, Imperial College LondonPage 36 The Money Market & Price Before considering production and supply, it is necessary to introduce the price level explicitly, and show how it relates to IS-LM. In practice, the price level “p” is an aggregate or average price level for the economy as a whole. When it increases, inflation is said to occur. In our model, however, we interpret “p” as the price for our (homogeneous) output good; i.e. “p” is the price per unit of “Y”. As was suggested above, in the IS-LM model the price level enters through the money demand curve. Intuitively, as the price level increases, so too does money demand. (As a first approximation, if prices double, households and firms will seek to hold twice as much money).

© Stephen Hall, Imperial College LondonPage 37 The Money Market & Price We’ve already seen an example of how the price level affects IS-LM: 1.An increase in P causes Md to increase. 2.An increase in Md implies a leftward shift in the LM-curve. 3.As a result, output Y e will decrease. 4.Combining 1 and 3 above, a higher P implies lower Y e. 5.The combinations of P and Y e that form an IS-LM equilibrium is an inverse relationship which we interpret as the “Price-Determined Demand Curve” (DD).

© Stephen Hall, Imperial College LondonPage 38 Deriving Price-Determined Demand “DD”: Example To see how one would obtain a price-determined demand curve from the IS-LM model, we will combine Examples 3 and 4d. Recall that Example 4d was the same as example 3, except that money demand had increased by 10%. We will now suppose that this increase in Md was due to a corresponding 10% increase in the price level, from P = 1 to P1 = 1.10.

© Stephen Hall, Imperial College LondonPage 39 From Example 3: IS-curve: Ye = 2,375 – 125i. Ms = 475 Md = Y – 70i Implies old LM-curve: Y = i Solving IS and LM simultaneously gave the equilibrium values Y = 1,500 and i = 7% (at P = £1.00).

© Stephen Hall, Imperial College LondonPage 40 From Example 4d: old IS-curve: Y = 2,375 – 125i old Ms = 475 new Md = Y – 77i Setting Ms = Md gave the new LM-curve New LM- Curve Ye= i Now, setting the old IS-curve equal to the new LM curve gives i = i which solves for i e =7.38 and Y e =1453 (at P= £1.10)

© Stephen Hall, Imperial College LondonPage 41 The price determined demand schedule (DDS) connects these points... DDS The price determined demand schedule Real money supply is nominal money supply divided by the price level – it influences the position of LM. Income r P IS LM 0 Y0Y0 P0P0 With price at P 0, LM is located at LM 0, and given IS, real income is in equilibrium at Y 0. At a lower price P 1, LM is at LM 1, and real income at Y 1. LM 1 Y1Y1 P1P1

© Stephen Hall, Imperial College LondonPage 42 DDS The price determined demand schedule Income r P IS 0 LM 0 Y0Y0 P0P0 LM 1 Y1Y1 P1P1 The DDS shows the different combinations of the price level and real income at which planned spending equals actual output once interest rates are set to keep money market equilibrium. Notice that a fall in price may also shift IS by increasing the value of household wealth via the real balance effect. IS 1 Y2Y2 The effect of this is to produce a flatter schedule DDS'. DDS'

© Stephen Hall, Imperial College LondonPage 43 Price-Determined Demand “DDS” There are several things to note about this demand curve: In most macroeconomic textbooks, this demand curve is known as the “aggregate demand curve”. Also note there can be only one equilibrium output level. Visually, then the Y e ’s on the IS-LM diagram and on the DD-curve diagram must be the same.

© Stephen Hall, Imperial College LondonPage 44 While an increase in the price level will affect the money demand and LM-curves as described above, the causality can also work in the other direction. That is, changes in the IS-LM equilibrium (due to, say, a fiscal policy change) will have corresponding effects on the DD-curve. As far as visually manipulating the DD-curve is concerned: In general, anything that causes the IS- LM equilibrium to shift to the right will also cause the DD curve to shift to the right!

© Stephen Hall, Imperial College LondonPage 45 Review Until now, we have assumed that equilibrium output was entirely demand determined. Before we introduce supply, it is useful to review our progressively more complicated models. Models 1 and 2: No interest rate or price level. Output determined entirely by demand. Implication: increase G to increase Y. Model 3, Interest rate introduced. Output still demand- determined. But increasing G pushes up interest rate and “crowds out” private investment. Therefore higher G implies lower I. Implications: depends upon investment responsiveness, but increasing G still a good idea.

© Stephen Hall, Imperial College LondonPage 46 Review Model 3 (money market): Money supply introduced as new variable under government control. Increasing Ms increases Y and lowers i. Implications: Isn’t expansionary monetary policy thus better than expansionary fiscal policy? Answer: Not necessarily, as we’ll show below. Increasing M may lower the interest rate. But it also leads to inflation, which reduces investment. There are also long- term problems (to be discussed), relating mostly to supply.