1. Goods and Financial Markets Together: The IS-LM Model

2. The Goods Market and the IS Relation
Equilibrium in the goods market exists when production, Y, is equal to the demand for goods, Z.
In the simple model (in chapter 3), the interest rate did not affect the demand for goods. The equilibrium condition was given by:

3. Investment, Sales (Y), and the Interest Rate (i)
Now, we no longer assume I (investment) is constant
We capture the effects of two factors affecting investment:
The level of sales/income (+)
The interest rate (-)

4. The Determination of Output
Taking into account the investment relation above, the equilibrium condition in the goods market becomes:

5. The Determination of Output
Equilibrium in the Goods Market
The demand for goods is an increasing function of output. Equilibrium requires that the demand for goods be equal to output.
When the ZZ line is flatter than the 45-degree line, an increase in output leads to a less than one-for-one increase in demand.

6. Deriving the IS Curve
The Effects of an Increase in the Interest Rate on Output
An increase in the interest rate decreases the demand for goods at any level of output.
When the ZZ line is flatter than the 45-degree line, an increase in output leads to a less than one-for-one increase in demand.

7. The IS Curve
Shifts of the IS Curve
An increase in taxes...

8. Financial Markets and the LM Relation
The interest rate is determined by the equality of the supply of and the demand for money:
M = nominal money stock $YL(i) = demand for money $Y = nominal income i = nominal interest rate

9. Real Money, Real Income, and the Interest Rate
The LM relation: In equilibrium, the real money supply is equal to the real money demand, which depends on real income, Y, and the interest rate, i:
Recall: before, we had the same equation but in nominal instead of real terms (nominal income and nominal money supply). Dividing both sides by P (the price level) gives us the equation above.

10. Deriving the LM Curve
The Effects of an Increase in Income on the Interest Rate

11. Shifts of the LM Curve
Shifts of the LM Curve
An increase in money...

12. The IS and the LM Relations Together
The IS-LM Model
Equilibrium in the goods market (IS).
Equilibrium in financial markets (LM).
When the IS curve intersects the LM curve, both goods and financial markets are in equilibrium.

13. Fiscal Policy, the Interest Rate and the IS Curve
Fiscal contraction: a fiscal policy that reduces the budget deficit.
Reducing G or increasing T
Fiscal expansion: increasing the budget deficit.
Increasing G or decreasing T
Taxes (T) and government expenditures (G) affect the IS curve, not the LM curve.

14. Fiscal Policy, the Interest Rate and the IS Curve
The Effects of an Increase in Taxes

15. Monetary Policy, the Interest Rate, and the LM Curve
Monetary contraction (tightening) refers to a decrease in the money supply.
An increase in the money supply is called monetary expansion.
Monetary policy affects only the LM curve, not the IS curve.

16. Monetary Policy, the Interest Rate, and the LM Curve
The Effects of a Monetary Expansion

17. Recent U.S. Monetary Policy

18. Movement in Interest Rate
Using a Policy Mix
The Effects of Fiscal and Monetary Policy.
Shift of IS
Shift of LM
Movement of Output
Movement in Interest Rate
Increase in taxes
left
none
down
Decrease in taxes
right up
Increase in spending
Decrease in spending
Increase in money
Decrease in money

19. German Unification and the German Monetary-Fiscal Policy Mix

20. U.S. Money Supply during the Great Depression (1928-1936)

21. U.S. Fiscal Policy during the Great Depression (1930-1947)

22. The U.S. Recession of 2001

23. Mr. Greenspan: