1. IS-LMEcon 302 Macroeconomic Analysis Slide #1 Goods & Financial Markets: The IS-LM Model The IS-LM Model The determination of output and interest rates in the short-run

2. IS-LMEcon 302 Macroeconomic Analysis Slide #2 Equilibrium in the goods market: Production (Y) = Demand (Z) Demand (Z)= C+I+G C=C(Y-T) T, I, & G are given The goods market and the IS relation Goods & Financial Markets: The IS-LM Model A Review

3. IS-LMEcon 302 Macroeconomic Analysis Slide #3 Equilibrium: Y=C(Y-T)+I+G Changes in C, I, & G impact the equilibrium Y The goods market and the IS relation Goods & Financial Markets: The IS-LM Model A Review (Continued)

4. IS-LMEcon 302 Macroeconomic Analysis Slide #4 The goods market and the IS relation Goods & Financial Markets: The IS-LM Model Investment, sales, and the interest rate Investment depends on: The level of sales The interest rate Therefore:

5. IS-LMEcon 302 Macroeconomic Analysis Slide #5 The IS curve Goods & Financial Markets: The IS-LM Model Equilibrium: Supply of Goods Demand for Goods (Z)

6. IS-LMEcon 302 Macroeconomic Analysis Slide #6 The IS curve Goods & Financial Markets: The IS-LM Model Demand, Z Output, Y b a Y Y´ ZZ (i) ZZ´ (i´ > i) ZZ: Demand, a function of Y for given i equilibrium at a, Y ZZ´: Demand with higher i equilibrium at b, Y´

7. IS-LMEcon 302 Macroeconomic Analysis Slide #7 The IS curve Goods & Financial Markets: The IS-LM Model Demand, Z Output, Y Y Y´ ZZ (i) ZZ´ (i´ > i) Interest Rate, i Output, Y A A Y i A´ Y´ i´ IS

8. IS-LMEcon 302 Macroeconomic Analysis Slide #8 Observation: Goods & Financial Markets: The IS-LM Model In the goods market, the higher the interest rate, the lower the equilibrium output.

9. IS-LMEcon 302 Macroeconomic Analysis Slide #9 i Y IS (T) The IS curve Goods & Financial Markets: The IS-LM Model Output, Y Interest Rate, i Shifts in the IS Curve: IS´ (T´ > T) Y´ An increase in taxes shifts the IS curve to the left

10. IS-LMEcon 302 Macroeconomic Analysis Slide #10 IS (G) Y i The IS curve Goods & Financial Markets: The IS-LM Model Output, Y Interest Rate, i Y´ IS´ (G´ > G) Shifts in the IS Curve: An increase in G shifts the IS curve to the right

11. IS-LMEcon 302 Macroeconomic Analysis Slide #11 Shifts in the IS curve Goods & Financial Markets: The IS Curve What do you think: How would a decrease in consumer confidence shift the IS curve?

12. IS-LMEcon 302 Macroeconomic Analysis Slide #12 Money market equilibrium revisited Financial Markets and the LM Relation Equilibrium Interest Rate: M=$YL(i) Equilibrium Interest Rate: M=$YL(i) M = nominal money supply (controlled by the Central Bank) $YL(i)= Demand for money (function of nominal income and the interest rate)

13. IS-LMEcon 302 Macroeconomic Analysis Slide #13 Real money, real income, and the interest rate Financial Markets and the LM Relation Real Income Real Money Supply =Real Money Demand: Y(L)i LM relation:

14. IS-LMEcon 302 Macroeconomic Analysis Slide #14 M d (for Y) M/P A i MsMs The LM curve Financial Markets and the LM Relation (Real) Money, M/P Interest Rate, i Increase in Y => increases M d which increases i A´ i´ M d ´ (for Y´ > Y)

15. IS-LMEcon 302 Macroeconomic Analysis Slide #15 A´ M d´ (for Y´ > Y) LM (M/P) A A Y i i M d (for Y) M/P MsMs i´ A´ Y´ i´ The LM curve Financial Markets and the LM Relation Interest Rate, i (Real) Money, M/P Interest Rate, i Income, Y

16. IS-LMEcon 302 Macroeconomic Analysis Slide #16 The LM curve Financial Markets and the LM Relation Shifts in the LM Curve: Showing changes in M & P Interest Rate, i (Real) Money, M/P b a M/P LM (M/P) Interest Rate, i Income, Y a b Y´ Y i i´ M d (for Y) i i´ MsMs M d´ (for Y´ > Y) M´/P LM´ (M´/P > M/P) i´ 2 i2i2 i2i2 M s´ a´ b´ a´ b´

17. IS-LMEcon 302 Macroeconomic Analysis Slide #17 Equilibrium Requires: The IS-LM Model Exercises

18. IS-LMEcon 302 Macroeconomic Analysis Slide #18 The IS-LM Equilibrium Graphically The IS-LM Model Exercises Output, Y Interest Rate, i IS Y i LM i & Y is the only interest rate, output combination that yields a simultaneous equilibrium in the goods and financial markets

19. IS-LMEcon 302 Macroeconomic Analysis Slide #19 Fiscal Policy, Activity, and the Interest Rate Question: What impact will the monetary expansion have on output and interest rate? A Scenario: The Fed engages in monetary expansion, i.e., it increases the money supply through open market operations Monetary Policy, Activity, and the Interest Rate

20. IS-LMEcon 302 Macroeconomic Analysis Slide #20 The IS-LM Equilibrium Graphically Fiscal Policy, Activity, and the Interest Rate Output, Y Interest Rate, i Y´ i´ LM (M/P) Y i A B IS A´ LM´ (M´/P > M/P) IS & LM: Before increasing M Equilibrium A: i & Y LM´: After increasing M Disequilibrium at i (A, B) New equilibrium A´: i´ & Y´ Monetary expansion lowered i & increased Y

21. IS-LMEcon 302 Macroeconomic Analysis Slide #21 The effects of fiscal and monetary policy Fiscal Policy, Activity, and the Interest Rate Shift in ISShift in LMMovement in Output Movement in Interest Rate Increase in taxesleftnonedown Decrease in taxesrightnoneup Increase in spendingrightnoneup Decrease in spending leftnonedown Increase in moneynonedownupdown Decrease in moneynoneupdownup

22. IS-LMEcon 302 Macroeconomic Analysis Slide #22 Using a Policy Mix Recall: Deficit reduction reduces output Expansionary fiscal policy increases the deficit Deficit reduction reduces output Expansionary fiscal policy increases the deficit The policy dilemma of 1992: Record high federal budget deficit (4.5% of GNP) High unemployment and slow growth The Clinton-Greenspan Policy Mix Solution: Policy Mix Deficit reduction and expansionary monetary policy

23. IS-LMEcon 302 Macroeconomic Analysis Slide #23 Using a Policy Mix The Clinton-Greenspan Policy Mix Output, Y Interest Rate, i Y´ i´ LM Y i B A IS´ A´ LM´ IS & LM: Before policy changes Equilibrium A: i & Y IS´: After deficit reduced B equilibrium without monetary expansion LM´ after monetary expansion New equilibrium i´, Y´ IS

24. IS-LMEcon 302 Macroeconomic Analysis Slide #24 Using a Policy Mix German Unification & the German Monetary Fiscal Tug-of-War The Scenario: Prior to unification, West Germany was exhibiting strong growth, investment After unification, strong fiscal stimulus from increased governmental spending on infrastructure and slow investment growth.

25. IS-LMEcon 302 Macroeconomic Analysis Slide #25 Using a Policy Mix German Unification & the German Monetary Fiscal Tug-of-War Output, Y Interest Rate, i Y´ i´ LM Y i A IS´ A´ LM´ A (i, Y) pre-unification equilibrium IS´: Post-unification IS LM´: Post-unification LM: Reduction in M to offset IS expansion A´(i´, Y´) post-unification equilibrium IS

26. IS-LMEcon 302 Macroeconomic Analysis Slide #26 Using a Policy Mix German Unification & the German Monetary Fiscal Tug-of-War The West German Economy, 1998-1991 1988198919901991 BDGP growth (%) 3.7 3.8 4.5 3.1 Investment*growth (%) 5.9 8.5 10.5 6.7 Budget surplus (% of GDP) -2.1 0.2 -1.8 -2.9 (minus sign: deficit) Interest rate (short term) 4.3 7.1 8.5 9.2

27. IS-LMEcon 302 Macroeconomic Analysis Slide #27 Adding Dynamics Observations: Changes in output adjust slowly to changes in the goods market (IS) Interest rates adjust instantaneously to changes in the financial markets (LM)

28. IS-LMEcon 302 Macroeconomic Analysis Slide #28 LM´ Adding Dynamics Dynamics Graphically Interest Rate, i Output, Y A´ YaYa LM Interest Rate, i Output, Y A B YaYa iAiA IS´ iAiA B IS YbYb Interest rates adjust instantaneously Output decreases slowly Adjusting to a tax increase Adjusting to a monetary contraction iBiB

29. IS-LMEcon 302 Macroeconomic Analysis Slide #29 Adding Dynamics The Dynamics of Monetary Contraction with IS-LM Output, Y Interest Rate, i Y´ i´ LM Y i A A´ IS A´´ LM´ A: Initial equilibrium (i & Y) LM´: After reducing money supply i rises to i´´ Higher i reduces demand and output slowly A´´ to A´ Equilibrium restored at A´: i´, Y´ i´´

30. IS-LMEcon 302 Macroeconomic Analysis Slide #30 Adding Dynamics A Summary Monetary policy changes interest rates rapidly and output slowly The Central Bank must consider the output lag when implementing monetary policy Monetary policy changes interest rates rapidly and output slowly The Central Bank must consider the output lag when implementing monetary policy

31. IS-LMEcon 302 Macroeconomic Analysis Slide #31 Does the IS-LM Model Actually Capture What Happens in the Economy? Does the IS-LM model pass two tests? Are the assumptions of IS-LM reasonable? Are the implications of IS-LM consistent with real-world observations? Are the assumptions of IS-LM reasonable? Are the implications of IS-LM consistent with real-world observations?

32. IS-LMEcon 302 Macroeconomic Analysis Slide #32 Does the IS-LM Model Actually Capture What Happens in the Economy? Are the assumptions of IS-LM reasonable? Are the implications of IS-LM consistent with real-world observations? Are the assumptions of IS-LM reasonable? Are the implications of IS-LM consistent with real-world observations? The Empirical Effects of an Increase in the Federal Funds Rate

33. IS-LMEcon 302 Macroeconomic Analysis Slide #33 Does the IS-LM Model Actually Capture What Happens in the Economy? The IS-LM model is consistent with economic observations The IS-LM model explains movements in economic activity over the short-run The IS-LM model is consistent with economic observations The IS-LM model explains movements in economic activity over the short-run Summary