IS-LM Revisited Simple Income Determination Properties of IS & LM Curves Equilibrium Output & Interest Rates Economic Policy

(1) Simple Income Determination *Eco 1002 *Goods Market (IS) *Exogenous Interest Rate & Prices *Endogenous Income (GDP) (2) IS-LM Model *Eco 2101 (Keynesian Short-Run) *(1) + Money Market *Endogenous Income & Interest Rate (Fixed P) Endogenous Policy

Simple Income Determination (Eco 1001) Behavioral Assumptions: Consumption = C (y, r) y = disposable income = Y – T r = interest rate MPC = where 0 < C y < 1 Investment = I(r) Government Purchases = G Exogenous:r, P, Fiscal Policy: G, T Endogenous:Y Linear Examples

Equilibrium: Some Basic Results: (interest rates and GDP) (Gov. Spending Multiplier) (Tax Multiplier)

IS-LM Model (Eco 2101) Goods & Money Market Equilibrium IS-LM Model Exogenous: P,Fiscal Policy: G, T Monetary Policy: M s Endogenous:Y and r

IS and the Goods Market Goods Market Equilibrium: Y = C(y,r) + I(r) + G(IS equation) wherey = Y – T = disposable income 0< C y < 1 I r < 0 G and T are exogenous policy variables

Properties of IS curve: Slope*: Government spending multiplier: (shifts right) Tax Multiplier: (shifts left)

LM and the Money Market Real Money Demand = L(Y,r) Money Market Equilibrium: M s = P*L(Y,r)(LM equation) M s is an exogenous policy variable.

Properties of LM curve Slope*: Real Money Supply: (shifts right)

The Simple IS-LM Model - (Y,r) which solves: (IS) (LM)

Policy in IS-LM Model Exogenous:P Endogenous: Y, r Policy Variables:G, Ms, T Fiscal Policy (1)Government Expenditures (dG) but less than 1/(1-C y )!

Crowding-out effect! Effectiveness of G: If (IS Flat) or(LM verticle) then.(Complete crowding-out!) (2) Taxes (dT): dY/dT = ?, dr/dT = ?

Monetary Policy (dM s ):

Effectiveness of monetary policy: If (IS vertical) or (LM flat) Then (Ineffective Monetary Policy)

Liquidity Trap and Interest Rate Insensitivity Great Depression YearURi  r = i - 

Recession Jan 2007 – Jan 2010, Federal funds rate cut from 6% to 1%. i UR Jan %4.6% Jan %5% Jan %7.7% Jan %10%

Business Cycles in IS-LM Shocks to Consumer confidence  )  C = C(Y,r  where C  > 0  dY*/d  > 0 dr*/d  Shocks to money demand  L = L(y,r  where L   > 0  dY*/d  < 0 dr*/d 

Endogenous Policy Monetary/Fiscal Policy responds to economic conditions to achieve goal. Objective:dY = 0 (output stability) OR dr = 0 (interest rate stability) Exogenous:Policies - M s or G, or T Shocks –  or  Endogenous:Policies - M s or G, or T

Example: An increase in G and Fed’s objective is to keep r constant (prevent crowding out). Step 1:Set dr = 0 Step 2:Treat dY and dM s as endogenous, dG as exogenous. Step 3:Use Cramer’s Rule to solve for dY/dG and dM s /dG. Suppose instead Fed wanted to keep output stable (dY = 0). Find dr/dG and dM s /dG.

Evaluation of Simple Keynesian IS- LM Models Provided reasonable explanation of business cycles. Guides policymakers on stabilizing economic fluctuations. Can be applied easily to think about current events.

Shortcomings Criticisms of IS-LM Model: (1)Emphasis on aggregate demand. (2)Static Model. (3)Lack of solid microeconomic foundations. Lucas Critique on Policy Evaluation Examples: Consumption, Phillips Curve

Modern Macro Dynamics Expectations (rational) Microeconomic Foundations Most modern macro models (New Classical and New Keynesian) have these features.