Ec 123 Section 51 THIS SECTION IS-LM Analysis –A simple model –A slightly more sophisticated model –Connection with our overlapping generations model?

Ec 123 Section 52 Keynesian demand-side explanation for recessions Lowered confidence in the future leads to low demand for goods and services. Low demand leads to unemployed resources (leakages). Prices are sticky; i.e, it takes quite a while for prices to change enough to absorb the unemployment. Note the two crucial assumptions in the story: Demand for goods and services is volatile. Prices are slow to adjust.

Ec 123 Section 53 IS-LM model IS-LM is a model of how the economy responds in the short run to shocks in demand as well as changes in economic policy. The model supposes that, in the short run, interest rates are very flexible but other prices, such as wages, are sticky and take longer to adjust. –We are implicitly assuming prices a fixed at an artificially high price so that there is excess supply (insufficient demand) (suppliers would be willing to supply more at the same price).

Ec 123 Section 54 IS-LM Terms For the IS/LM model, terms such as money and income and savings and investment have more precise meanings than they do in informal usage. It is important to know the precise definitions. Money = M1 = currency plus demand deposits, where demand deposits are non-interest bearing checking accounts. By the M1 definition, holding a bank savings account is not holding money. Y = real income = real GDP, the total output of goods and services for the economy. Income is a flow, meaning, it is measured over time (ex., quarterly or annually). –Note: Income is the total goods and services the economy produces. Money and income are not the same thing. Typically, a country uses the same stock of money several times to purchase its annual income!

Ec 123 Section 55 IS-LM Terms T = total taxes paid to the government. Y - T = disposable income. C = expenditures devoted to consumption. G = total expenditures by government I = private investment = total private expenditures on plant and equipment. S = total savings

Ec 123 Section 56 IS-LM Terms It is important to recall the difference between savings and investment. Saving is the act of deciding to put income aside. Investment is the act of deciding what project to do with the savings. Example: Suppose that, in order to raise the funds to build a new plant, a firm issues bonds. The bond-holders are saving, and the bond issuer (the firm) is investing. Alternatively, bond-holders supply savings and bond-issuers demand savings. –In equilibrium (without govt.) I = S r = the interest rate paid by investors to compensate savers for funds. For simplicity, we assume there is one interest rate.

Ec 123 Section 57 Relationships between variables I(r) is the investment function and is obviously a function of the interest rate. The interest rate is the price investors pay for funds, so when r goes up, I goes down. M D (r, Y) is money demand or the demand for liquidity. Money demand is a function of the interest rate and income. When the interest rate rises (all other things fixed), the opportunity cost of holding money increases, and so money demand falls. When income rises (all other things fixed), agents will want to spend more, and so money demand rises.

Ec 123 Section 58 Deriving the IS Curve Suppose for the moment that all income in the economy is devoted to consumption. How much consumption will consumers choose? We assume that consumption is a function of disposable income, Y - T. The following is an example: C = (Y - T) The coefficient on the Y e -T term can be interpreted as the marginal propensity to consume. Suppose the tax bill, T, is a fixed number. In equilibrium expenditures (on consumption) must equal expected income, or Y d = C, Since we are supposing C is the only use for income, Y d = Y.

Ec 123 Section 59 Deriving the IS Curve Income (Y) Y d Expenditures Y d =Y C equilibrium

Ec 123 Section 510 Deriving the IS Curve Income (Y) YdYd Y d =Y C The other elements of the expenditure breakout of GDP are assumed to be autonomous, or they do not depend directly on (expected) income. Suppose the interest rate is fixed. G I(r) Investment level is fixed given the interest rate. Government spending C+I+G equilibrium

Ec 123 Section 511 Deriving the IS Curve Now suppose that the interest rate (r) varies. When r moves, we expect that I will move in the opposite direction. With the change in investment, the goods market will move to a new equilibrium. C+I(r 0 )+G C+I(r 1 )+G New equilibrium I(r 1 ) Interest rate goes down from r 0 to r 1 Income (Y) YdYd Y d =Y I(r 0 )

Ec 123 Section 512 The IS curve Y0Y0 Output (Y) IS Y1Y1 Int. Rate (r) r0r0 r1r1 Income (Y) YdYd Y d =Y C+I(r 0 )+G C+I(r 1 )+G Interest rate goes down from r 0 to r 1 The IS curve gives the combinations of Y and r that produce equilibrium in the goods market.

Ec 123 Section 513 What determines how steep the IS curve will be? Q0Q0 Output (Y) Q1Q1 r r0r0 r1r1 Income (Y) YdYd C+I(r 0 )+G The responsiveness of I to interest rates determines the slope of the IS curve. (interest rate elasticity) More responsive I implies a flatter IS curve. C+I’(r 1 )+G Q’ 1 IS C+I(r 1 )+G IS’

Ec 123 Section 514 The Money Market The LM curve is determined by equilibrium in the money market. Assume that the supply of money M S is fixed (or inelastic) in the short run. Then the equilibrium will be the interest rate (the price of money) where M D = M S. Money M D (Y 1 ) M D (Y 0 ) MSMS Interest Rate r r0r0 r1r1 If income increases (Y 1 > Y O ), demand for money will increase (shift). If the Fed does not increase the money supply, interest rates will increase (to r 1 ).

Ec 123 Section 515 Deriving the LM curve Money LM The LM curve gives the combinations of Y and r that produce equilibrium in the money market. M D (Y 0 ) MSMS Int. Rate r M D (Y 1 ) r0r0 r1r1 Output (Y) Interest Rate r Y0Y0 r0r0 r1r1 Y1Y1

Ec 123 Section 516 What determines how steep the LM curve will be? M’ D (Y 0 ) New LM curve is steeper if money demand is less sensitive to changes in interest rates. M’ D (Y 1 ) LM’ Money demand is less sensitive to changes in the interest rate. (less elastic) M D (Y 0 ) LMM D (Y 1 ) r1r1 r1r1 r’ 1 r0r0 r0r0 Money MSMS Output (Y) Y0Y0 Interest Rate r Y1Y1

Ec 123 Section 517 Putting the IS and LM curves together IS Output (Y) Interest Rate r Int. Rate r LM Describes all possible equilibria in the goods market. Describes all possible equilibria in the money market.

Ec 123 Section 518 Putting the IS and LM curves together IS Output (Y) Int. Rate r LM Only combination of Y and r that is an equilibrium in both the goods and money market. r Y0Y0

Ec 123 Section 519 IS-LM and policy analysis IS-LM analysis is good for understanding the qualitative effects of various policy changes or short term shocks to the system. Changes in fiscal policy (i.e., changes in G and T) will shift the IS curve. Changes in monetary policy will shift the LM curve. Shocks (exogenous events) may also shift either curve.

Ec 123 Section 520 The 2008 Stimulus Package Y d =Y C+I(r 0 )+G’ Y1Y1 Govt. spending shifts from G to G’. Y0Y0 Output (Y) IS Int. Rate (r) r0r0 Income (Y) YdYd C+I(r 0 )+G Expansionary fiscal policies shift the IS curve to the right. Contractionary fiscal policies shift the IS curve to the left. IS’

Ec 123 Section 521 The 2008 Stimulus Checks (150 billion) r IS Output (Y) Int. Rate r LM Y IS’ r’ Y’ Output goes up (Y’ > Y) but so does interest rates (r’ > r).

Ec 123 Section 5 22 What determines the size of the shift? Y d =Y C+I(r 0 )+G’ Y1Y1 Y0Y0 Output (Y) IS Int. Rate (r) r0r0 Income (Y) YdYd The slope of the consumption line determines the size of the shift. C’ has a higher marginal propensity to consume than C so fiscal policy results in more growth. IS’ C+I(r 0 )+G IS’ C’+I(r 0 )+G C’+I(r 0 )+G’ Expansionary Fiscal Policy: G’>G Y’ 1

Ec 123 Section 523 The Fed announces a lower interest rate target r’ Money LM MSMS Int. Rate r M D (Y 0 ) r Output (Y) Interest Rate r r Y0Y0 M’ S LM’ To achieve the lower target (r’) the Fed must increase the money supply.

Ec 123 Section 524 The Fed announces a lower interest rate target. LM Y’ Output (Y) Int. Rate r IS r Y Output goes up (Y’ > Y) but interest rates do not go down as much as targeted. r’ LM’ r” Expansionary monetary policies shift the LM curve to the right. Contractionary monetary policies shift the LM curve to the left.

Ec 123 Section 525 Relative slope of IS and LM curves determines the effectiveness of fiscal v. monetary policy IS LM Output (Y) Int. Rate r LM r Y0Y0 IS Output (Y) Int. Rate r r Y0Y0 Good for monetary policy: Big growth with little change in interest rates. LM’ r’ Y’ Good for fiscal policy: Big growth with little crowding out. IS’ r’ Y’

Ec 123 Section 526 Summary The IS curve: Gives the combinations of Y and r that produce equilibrium in the goods market. Slopes down. Shifts to the right when there is an increase in government spending and shifts to the left when there is a decrease in government spending. Shifts to the left when taxes increase. Shifts to the right when taxes decrease. Is relatively flat in the interest elasticity of investment is relatively high. Is relatively steep if the interest elasticity of investment is relatively low. The LM curve: Gives the combination of Y and r that produce equilibrium in the money market. Slopes upward. Shifts downward with an increase in the money supply and shifts upward with a decrease in the money supply. Is relatively steep if the interest elasticity of money demand is relatively low. Is relatively flat if the interest elasticity of money demand is relatively high.