Putting it all Together IS-LM-FE

The Macroeconomy

Labor Markets

The Macroeconomy Labor Markets –Labor supply is determined by household preferences –Labor demand is determined by productivity (w/p = MPL) –In equilibrium, Labor Supply = Labor Demand –The real wage (w/p) is determined

The Macroeconomy Capital Markets

The Macroeconomy Capital Markets –Savings is determined by household behavior –Investment is determined by productivity Pk*(r+d) = P*MPK –In Equilibrium, Savings = Investment –The real interest rate is determined

The Macroeconomy Money Markets

The Macroeconomy Money Markets –Money Demand is determined by households –Money Supply is chosen by the central bank –In equilibrium, Money Demand = Money Supply –The Aggregate price level is determined

IS-LM-FE IS-LM-FE theory is nothing new. Its simply a more compact representation of labor/capital/money markets

IS-LM-FE IS-LM-FE theory is nothing new. Its simply a more compact representation of labor/capital/money markets –FE (Full employment) represents the labor market equilibrium

IS-LM-FE IS-LM-FE theory is nothing new. Its simply a more compact representation of labor/capital/money markets –FE (Full employment) represents the labor market equilibrium –LM (Liquidity/Money): Represents the Money Market equilibrium

IS-LM-FE IS-LM-FE theory is nothing new. Its simply a more compact representation of labor/capital/money markets –FE (Full employment) represents the labor market equilibrium –LM (Liquidity/Money) represents the money market equilibrium –IS (Investment/Savings) represents the capital market equilibrium

Labor Market Equilibrium and the FE curve Recall that a labor market equilibrium defines a real wage such that labor demand equals labor supply. Once employment is determined, output can be found.

Labor Market Equilibrium and the FE curve Recall that a labor market equilibrium defines a real wage such that labor demand equals labor supply. Once employment is determined, output can be found. How is this labor market equilibrium effected by interest rates?

Labor Market Equilibrium and the FE curve Recall that a labor market equilibrium defines a real wage such that labor demand equals labor supply. Once employment is determined, output can be found. How is this labor market equilibrium effected by interest rates? –Is labor demand influenced by rising/falling interest rates?

Labor Market Equilibrium and the FE curve Recall that a labor market equilibrium defines a real wage such that labor demand equals labor supply. Once employment is determined, output can be found. How is this labor market equilibrium effected by interest rates? –Is labor demand influenced by rising/falling interest rates? NO

Labor Market Equilibrium and the FE curve Recall that a labor market equilibrium defines a real wage such that labor demand equals labor supply. Once employment is determined, output can be found. How is this labor market equilibrium effected by interest rates? –Is labor demand influenced by rising/falling interest rates? NO –Is labor supply influenced by rising/falling interest rates?

Labor Market Equilibrium and the FE curve Recall that a labor market equilibrium defines a real wage such that labor demand equals labor supply. Once employment is determined, output can be found. How is this labor market equilibrium effected by interest rates? –Is labor demand influenced by rising/falling interest rates? NO –Is labor supply influenced by rising/falling interest rates? NO

Labor Market Equilibrium and the FE curve Recall that a labor market equilibrium defines a real wage such that labor demand equals labor supply. Once employment is determined, output can be found. How is this labor market equilibrium effected by interest rates? –Is labor demand influenced by rising/falling interest rates? NO –Is labor supply influenced by rising/falling interest rates? NO If both labor supply and labor demand are independent of interest rates, then equilibrium employment is independent of interest rates.

Labor Market Equilibrium and the FE curve Suppose that at an interest rate of 5%, equilibrium employment produces $15T of output

Labor Market Equilibrium and the FE curve Suppose that at an interest rate of 5%, equilibrium employment produces $15T of output If interest rates fall to 3%, neither labor supply nor labor demand are affected and output is still $15T

Labor Market Equilibrium and the FE curve Suppose that at an interest rate of 5%, equilibrium employment produces $15T of output If interest rates fall to 3%, neither labor supply nor labor demand are affected and output is still $15T The FE curve represents all possible labor market equilibria

Labor Market Equilibrium and the FE curve How would a positive technology shock influence the FE curve?

Labor Market Equilibrium and the FE curve How would a positive technology shock influence the FE curve? A positive technology shock would raise employment and output – regardless of the interest rate. Therefore, the FE curve moves to the right

Labor Market Equilibrium and the FE curve How would a positive technology shock influence the FE curve? A positive technology shock would raise employment and output – regardless of the interest rate. Therefore, the FE curve moves to the right In fact, any shock which increases (decreases) employment/output moves the FE curve to the right (left)

Capital Markets and the IS Curve Recall that a capital market equilibrium defines an interest rate such that savings equals investment

Capital Markets and the IS Curve Recall that a capital market equilibrium defines an interest rate such that savings equals investment How would the capital market equilibrium be influenced by a drop in interest rates?

Capital Markets and the IS Curve Recall that a capital market equilibrium defines an interest rate such that savings equals investment How would the capital market equilibrium be influenced by a drop in interest rates? –Is savings affected?

Capital Markets and the IS Curve Recall that a capital market equilibrium defines an interest rate such that savings equals investment How would the capital market equilibrium be influenced by a drop in interest rates? –Is savings affected? Yes, savings falls.

Capital Markets and the IS Curve Recall that a capital market equilibrium defines an interest rate such that savings equals investment How would the capital market equilibrium be influenced by a drop in interest rates? –Is savings affected? Yes, savings falls. –Is investment affected?

Capital Markets and the IS Curve Recall that a capital market equilibrium defines an interest rate such that savings equals investment How would the capital market equilibrium be influenced by a drop in interest rates? –Is savings affected? Yes, savings falls. –Is investment affected? Yes, investment rises.

Capital markets and the IS Curve That is, a drop in interest rates would create excess demand for investment. How would income have to adjust to return to an equilibrium?

Capital markets and the IS Curve That is, a drop in interest rates would create excess demand for investment. How would income have top adjust to return to an equilibrium? A rise in income would increase savings and eliminate the excess demand

Capital markets and the IS Curve Suppose that with output of $10T, an interest rate of 5% clears the capital market

Capital markets and the IS Curve Suppose that with output of $10T, an interest rate of 5% clears the capital market A capital market equilibrium with an interest rate of 3% would necessarily be associated with a higher level of output (say, $15T)

Capital markets and the IS Curve The IS curve represents all possible capital market equilibria

Capital markets and the IS Curve The IS curve represents all possible capital market equilibria Suppose that a negative technology shock lowers the demand for investment. How would the IS curve be affected?

Capital Markets and the IS Curve Lower investment demand would result in lower interest rates. Note that total output doesn’t change – only the composition of demand (investment falls, consumption rises)

Capital markets and the IS curve A negative technology shock results in an equilibrium with the same total output, but a lower interest rate. Hence, the IS curve shifts down

Capital markets and the IS curve A negative technology shock results in an equilibrium with the same total output, but a lower interest rate. Hence, the IS curve shifts down In fact, any shock that causes interest rates in the capital market to fall (rise) causes the IS curve to shift down (up)

Money Markets and the LM Curve Recall our money market equilibrium M = k*PY Where M is nominal money supply, PY is nominal income and k is a constant that is negatively related to the interest rate

Money Markets and the LM Curve Recall our money market equilibrium M = k*PY Where M is nominal money supply, PY is nominal income and k is a constant that is negatively related to the interest rate We considered two possible types of equilibrium –Classical: Prices adjust to clear the money market –Keynesian: Prices are fixed, output and interest rates adjust to clear the market

Money Markets and the LM Curve Given a fixed supply of real balances (M/P) each interest rate will have a corresponding level of output so that money demand equals money supply ( M/P = k*Y)

Money Markets and the LM Curve Given a fixed supply of real balances (M/P) each interest rate will have a corresponding level of output so that money demand equals money supply ( M/P = k*Y) Suppose interest rates fall. How is the equilibrium affected?

Money Markets and the LM Curve Given a fixed supply of real balances (M/P) each interest rate will have a corresponding level of output so that money demand equals money supply ( M/P = k*Y) Suppose interest rates fall. How is the equilibrium affected? –Real Money Supply is assumed to be fixed –Money demand will, however, rise, due to the lower opportunity cost of holding dollars (velocity falls)

Money Markets and the LM Curve Given a fixed supply of real balances (M/P) each interest rate will have a corresponding level of output so that money demand equals money supply ( M/P = k*Y) Suppose interest rates fall. How is the equilibrium affected? –Real Money Supply is assumed to be fixed. –Money demand will, however, rise, due to the lower opportunity cost of holding dollars (velocity falls) Therefore, with fixed prices, lower interest rates result in excess demand for dollars. How do we get back to an equilibrium?

Money Markets and the LM Curve Given a fixed supply of real balances (M/P) each interest rate will have a corresponding level of output so that money demand equals money supply ( M/P = k*Y) Suppose interest rates fall. How is the equilibrium affected? –Real Money Supply is assumed to be fixed –Money demand will, however, rise, due to the lower opportunity cost of holding dollars (velocity falls) Therefore, with fixed prices, lower interest rates result in excess demand for dollars. How do we get back to an equilibrium? Income will have to fall to lower money demand.

Money Markets and the LM Curve The LM curve represents the combination of output and interest rates that clear the money market given a level of real money balances (M/P) The upward slope reflects that as interest rates rise (thus lowering money demand), output must rise to compensate

Money Markets and the LM Curve What shifts the LM curve?

Money Markets and the LM Curve What shifts the LM curve? If prices are fixed, the LM curve is controlled by the central bank.

Money Markets and the LM Curve What shifts the LM curve? If prices are fixed, the LM curve is controlled by the central bank. An increase in the money supply must be matched by an equal rise in money demand (through lower interest rates and higher income) – LM moves right.

The LM curve and classical economics Note that LM curve is drawn for a fixed supply of real balances (M/P). If prices are fixed, an increase (decrease) in the money supply shifts the LM curve right (left)

The LM curve and classical economics Note that LM curve is drawn for a fixed supply of real balances (M/P). If prices are fixed, an increase (decrease) in the money supply shifts the LM curve right (left) However, in classical economics, prices are flexible. Therefore any increase in money supply is matched by an equal increase in prices – (M/P) is constant. Therefore, the central bank has no control over the LM curve.

Putting it all together: IS-LM-FE

FE: Labor market equilibrium

Putting it all together: IS-LM-FE FE: Labor market equilibrium IS: Capital market equilibrium

Putting it all together: IS-LM-FE FE: Labor market equilibrium IS: Capital market equilibrium LM: Money market equilibrium

IS-LM-FE and Classical Economics Recall that classical economics emphasizes flexible prices.

IS-LM-FE and Classical Economics Recall that classical economics emphasizes flexible prices. Flexible prices eliminates the need for the LM curve (the price level will always adjust to insure that the money market clears)

Classical Economics and Technology Shocks Suppose that the economy hit by a temporary negative productivity shock

Classical Economics and Technology Shocks Suppose that the economy hit by a temporary negative productivity shock The FE curve shifts to the left. The shock is temporary, so IS is unaffected. The result is lower output and higher interest rates. What happens to prices?

Classical Economics and Technology Shocks Suppose that the economy hit by a temporary negative productivity shock The FE curve shifts to the left. The shock is temporary, so IS is unaffected. The result is lower output and higher interest rates. What happens to prices? Higher interest rates as well as lower output lower money demand – this causes prices to rise.

Classical Economics and Technology Shocks Suppose that the economy hit by a temporary negative productivity shock The FE curve shifts to the left. The shock is temporary, so IS is unaffected. The result is lower output and higher interest rates. What happens to prices? Higher interest al well as lower output lower money demand – this causes prices to rise. Higher prices lowers real balances – LM shifts left.

Classical Economics and Monetary Policy The LM curve is irrelevant in classical economics because the Fed can’t influence real balances. For example, a decrease in money supply will result in a proportional decrease in prices – the LM curve doesn’t move.

IS-LM-FE and Keynesian Economics Keynesian economics stresses fixed prices – this gives the central bank control over the LM curve (i.e., the ability to influence output)

IS-LM-FE and Keynesian Economics Keynesian economics stresses fixed prices – this gives the central bank control over the LM curve (i.e., the ability to influence output) Once the level of output has been determined, the labor market provides the appropriate level of production. Therefore, in Keynesian economics, it’s the FE curve that’s irrelevant

Keynesian Economics and Monetary Shocks Suppose that the federal reserve decreases the money supply (prices are fixed)

Keynesian Economics and Monetary Shocks Suppose that the federal reserve increases the money supply (prices are fixed) The decrease in real balances shifts the LM curve to the left. Output (and employment) falls and interest rates rise.

Keynesian Economics and Monetary Shocks Suppose that the federal reserve increases the money supply (prices are fixed) The decrease in real balances shifts the LM curve to the left. Output (and employment) falls and interest rates rise. Lower output and employment is represented by the FE curve shifting left.

Keynesian Economics and Monetary Shocks Suppose that the federal reserve decreases the money supply (prices are fixed) The increase in real balances shifts the LM curve to the left. Output (and employment) falls and interest rates rise. However, once prices are allowed to adjust, prices drop – this shifts the LM curve back to the right. (Money is neutral in the long run)

Keynesian Economics and Technology Shocks With a temporary decrease in technology, the FE curve shifts left, but the equilibrium remains at the intersection of Is and LM – the economy is at “above capacity” employment.