IS-LM 2: Examples See Mankiw 12.1 &

The intersection determines the unique combination of Y and r that satisfies equilibrium in both markets. The LM curve represents money market equilibrium. Recap: Equilibrium in IS -LM The IS curve represents equilibrium in the goods market. IS Y r LM r1r1 Y1Y1 2

Policy & Shocks in ISLM Fiscal policy: change G and/or T Monetary Policy: Change M Shocks to the economy –Great Depression –Crisis of

Fiscal Policy and Crowding out Shift in the IS curve: G is in defn of IS Shift along the LM curve: G is not in defn of LM IS shifts to right: for any interest rate output will rise –Remember multiplier Crowding out –Final  Y is less then if we looked at goods market only –G  Y  L  r  I  Y –Public expenditure replaces private investment r y LM IS 1 IS 0 4

warning: v simple cons function IS 1 FP & Crowding out 1. IS curve shifts right Y r LM r1r1 Y1Y1 IS 2 Y2Y2 r2r This raises money demand, causing the interest rate to rise… …which reduces investment, so the final increase in Y 3. 5

IS 1 1. A tax cut Y r LM r1r1 Y1Y1 IS 2 Y2Y2 r2r2 Consumers save (1  MPC) of the tax cut, so the initial boost in spending is smaller for  T than for an equal  G… and the IS curve shifts by …so the effects on r and Y are smaller for  T than for an equal  G. 2. 6

Balanced Budget Multiplier The expression for the multiplier is from a very simple model But the general idea that tax multiplier is smaller than expenditure multiplier is true Why? Savings This implies that balanced budget multiplier is greater than zero. In the very simple model it is 1 7

r Y LM 1 IS LM 2 An Increase in Money Supply Money supply affects LM direclty Shift in LM along IS LM shift: for any output level interest rates will fall New eqm. has lower r and higher Y There is a crowding out effect her also. –  r less than if we looked at money market only –Y rises and puts extra demand for money M  r  > I  > Y  > L  > r 8

Interaction between monetary & fiscal policy Model: –Monetary & fiscal policy variables (M, G, and T ) are exogenous. Real world: –Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa. –Such interactions may alter the impact of the original policy change. 9

If Gov raises G, the IS curve shifts right. IS 1 Change G & M: Extra effect Y r LM 1 r1r1 Y1Y1 IS 2 Y2Y2 r2r2 To keep r constant, CB increases M to shift LM curve right. LM 2 Y3Y3 Results: No Crowding out 10

IS 1 Change G & M: No effect on Y Y r LM 1 r1r1 IS 2 Y2Y2 r2r2 To keep Y constant, CB reduces M to shift LM curve left. LM 2 Results: complete CO Why? Inflation Example German unification Y1Y1 r3r3 If Gov raises G, the IS curve shifts right. 11

Estimates of fiscal policy multipliers from the DRI macroeconometric model of US Assumption about monetary policy Estimated value of  Y /  G Fed holds nominal interest rate constant Fed holds money supply constant Estimated value of  Y /  T  1.19 

Shocks to the Ecomomy: IS Exogenous changes in the demand for goods & services. Examples: – Housing boom or crash  change in households’ wealth   C – Note that this implies a more complicated consumption function (see later) – change in business or consumer confidence or expectations   I and/or  C – Expectations are not in the simple model (so far) 13

LM Shocks Exogenous changes in the supply/demand for money. Examples: – A wave of credit card fraud increases demand for money. – More ATMs or the Internet reduce money demand – Leaving the euro 14

Example: Irish Housing Mkt 15 IS 1 Y r LM 1 r1r1 Y1Y1 IS 2 Y2Y2 r2r2 Decline in house prices affects consumers wealth. C falls (need more complicated C fn) IS shifts left, causing r and Y to fall. Policy response? Caveat: SOE 15

Example: US recession of 2001 Causes: 1) Stock market decline   C Causes: 2) 9/11 –increased uncertainty –fall in consumer & business confidence –result: lower C & I Causes: 3) Corporate accounting scandals –Enron, WorldCom, etc. –reduced stock prices, discouraged investment 16

Example: US IS 1 Y r LM 1 r1r1 Y1Y1 IS 2 Y2Y2 r2r2 Multiple reasons for decline in C & I IS shifts left Make sure you understand why? Hint: this is a typical exam question. 17

The Policy Response Fiscal policy: –tax cuts in 2001 and 2003 (T down) –spending increases (G up) –Shift IS curve to right (why?) Monetary policy –Increase in M –shifted LM curve down (why?) 18 US Recession 2001

IS 2 Policy Response 2001 Y r LM 2 IS 1 LM 1 Economy starts at A Shock: IS 1  IS 2 A  B FP: IS 2  IS 1 MP: LM 1  LM 2 B  C 19 A B C

Great Depression The biggest economic crash in modern times Bigger than the crisis now Policy makers learned a lot from great depression Three questions 1.What was the cause? 2.What was the policy response? 3.What should have been the policy response? 20

The Great Depression Unemployment (right scale) Real GNP (left scale) billions of 1958 dollars percent of labor force 21

IS Shocks Stock market crash  exogenous  C –Oct 1929–Dec 1929: S&P 500 fell 17% –Oct 1929–Dec 1933: S&P 500 fell 71% Drop in investment –Correction after overbuilding in the 1920s. –Widespread bank failures made it harder to obtain financing for investment. –Parallels with recent history Contractionary fiscal policy –Politicians raised tax rates and cut spending to combat increasing deficits. 22

Monetary Shocks (LM) Asserts that the Depression was largely due to huge fall in the money supply. Milton Friedman: “Monetarist” Approach Evidence: M fell 25% during 1929–33. But, two problems with this hypothesis: –P fell even more, so M/P actually rose slightly during 1929–31. –nominal interest rates fell, which is the opposite of what a leftward LM shift would cause. 23

The effects of falling prices Strictly speaking ISLM not much use for analyzing deflation. –We will return to this later The destabilizing effects of unexpected deflation: debt-deflation theory  P (if unexpected)  transfers purchasing power from borrowers to lenders  borrowers spend less, lenders spend more  if borrowers’ propensity to spend is larger than lenders’, then aggregate spending falls, the IS curve shifts left, and Y falls 24

Another Depression is unlikely Policymakers (or their advisers) now know much more about macroeconomics: –The Fed knows better than to let M fall so much, especially during a contraction. –Fiscal policymakers know better than to raise taxes or cut spending during a contraction. Federal deposit insurance makes widespread bank failures very unlikely. Automatic stabilizers make fiscal policy expansionary during an economic downturn. 25

The 2008–09 financial crisis & recession 2009: Real GDP fell, u-rate approached 10% in US Important factors in the crisis: –subprime mortgage crisis –bursting of house price bubble, rising foreclosure rates –falling stock prices –failing financial institutions –declining consumer confidence, drop in spending on consumer durables and investment goods 26

Change in U.S. house price index and rate of new foreclosures, 1999–

Consumer sentiment and growth in consumer durables and investment spending 28

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The Policy Response US –Tax cuts –Obama “Stimulus” –Fed “Quantitative Easing” Combination makes situation better Ireland –Tax rises –Cuts in expenditure –No change in money supply Combination makes situation worse Why do this? 32

The US r y LM 0 IS 1 IS 0 33 Start at A The shock: –IS 0  IS 1 –A  B The stimulus: –IS 1  IS 2 –B  C Q easing: –LM 0  LM 0 –C  D IS 2 LM 1 A B C D

Ireland r y LM 0 IS 2 IS 0 34 Start at A The shock: –IS 0  IS 1 –A  B Austerity: –IS 1  IS 2 –B  C IS 1 A C B D

Conclusions 1.IS curve is equilibrium in the goods market –r  I  Y 2.LM curve is equilibrium in Money market –Y  L  r 3.Simultaneous equilibrium –Unique stable 4.Fiscal and Monetary policy –Crowding out –Quantitative easing –Shocks –examples

What’s Missing Three Big Things missing from the model 1.Expectations or forward looking behaviour –Hint of this in consumption out of wealth 2.No price adjustment –Very simplistic approach to supply side 3.Ignore openness of economy –Most countries are SOE 36