1. Goods and Financial Markets1: IS-LM
Goal: link the goods and the financial markets into a more general model that will determine the equilibrium and the equilibrium in the economy (with prices)
The goods market will be represented by the
curve (standing for investment-savings)
The financial markets (money market) will be represented by the curve (liquidity-money)
1. The Hicks-Hansen model based on Keynes’ General Theory
BlCh5

2. The goods market - IS curve
Equilibrium condition
will provide the link to the financial markets
Determinants of investment:
If increase, producers might want to increase their productive capacity by investing in capital goods.
If , producers find that borrowing to add new capital becomes more expensive
BlCh5

3. Equilibrium in the goods market becomes: Y = Basically
When i I and Ye
When i I and Ye
The ZZ curve shifts now as the interest rate changes and a multiplier effect takes place
If MPI is the marginal propensity to invest out of new income, assume that MPC + MPI < 1
The slope of the ZZ curve is now and the interest rate is included in the intercept
BlCh5

4. Construction of the IS curveZ
When the interest rate increases, I (Y, i) drops and the ZZ curve shifts down. The economy contracts from Ye to Y’e.
E and E’ correspond to 2 combinations of i and Y, such that the good market is in equilibrium. i Y
Y’e Ye i i’ i Y
Y’e Ye
BlCh5

5. The IS curve Y = Definition: All the combinations
i.e. the above equation is satisfied
Shift of the IS: A change in any of the
in the equation will cause IS to shift.
Shift variables:
(confidence variables)
(fiscal policy variables)
BlCh5

6. Expansionary fiscal policy: increase in G
Y=Z Z
ZZ (G)
When G increases by ∆G, ZZ shifts up and IS shifts to the right.
An increase in T would has the opposite effect as it is contractionary. Y Ye i E i IS Y Ye
BlCh5

7. Shifts of IS Expansionary Contractionary i G T c0 G I0 T c0 I0 IS Y
BlCh5

8. The financial markets - LM curve
Equilibrium condition1:
supply of money = demand for money
Ms = or Ms/P =
(Ms/P is the real money supply)
It is clear that both LM and IS are relations between i and Y
1. The bonds market is automatically in equilibrium when the money market is in equilibrium
BlCh5

9. Construction of the LM curveMs i i i0
Md(Y0)
M/P
Y Y1 Y
BlCh5

10. The LM curve
Ms =
Definition: All the combinations of and such that the ( and
) are in equilibrium
Shift of the LM curve: a change in the money or a change in or an exogenous shift in the money demand
An in the money supply ( or a
in price) is expansionary
A change in the velocity of money
BlCh5

11. Expansionary monetary policy: an increase in MsLM i A i0
Md(Y0)
M/P Y0 Y
BlCh5

12. Shifts of LM
Contractionary i LM Ms P V Ms P V
Expansionary Y
BlCh5

13. sloped, they will intercept in E determining Y and i in equilibrium.
The IS-LM model
Y = IS curve
M/P = LM curve
IS is sloped and LM is
sloped, they will intercept in E determining Y and i in equilibrium.
At that point, all three markets :
two financial markets and the goods market, are
BlCh5

14. The IS-LM graph i Y
BlCh5

15. Problem # 4 IS-LM model: C = 200+ .25YD I = 150 + .25Y - 1000i
G = 250 and T = 200
(M/P)d = 2Y i
M/P = 1,600 IS LM
BlCh5

16. Derive the IS curve: Y = C + I + G
Y = Y- .25T Y i + 250
= Y i
Y - .5Y = i
Y (1 - .5) = i
Y = [1/.5] ( i) multiplier = 2
IS curve: Y = i
BlCh5

17. Derive the LM curve: YL(i) = M/P 2Y - 8000i = 1600 8000i = 2Y - 1600
LM curve: i = Y/
c. Solve IS-LM for equilibrium Y
Y = i
= (Y/ )
= Y + 400
1.5Y = so Y = 1000
BlCh5

18. Replace equilibrium Y and i into C and I
i = Y/
= 1000/
= = so i = 5%
Replace equilibrium Y and i into C and I
C = * *200 = 400
I = * *.05 = 350
G = 250
So Y = = 1000
BlCh5

19. Fiscal Policy Instruments: Curve affected: Effect:
Expansionary: when (G-T)
or G or T
IS shifts to the
Contractionary: when (G-T)
or G or T
BlCh5

20. A fiscal expansion The economy moves along the LM curve from A to A’ iie A IS Ye Y
BlCh5

21. Mechanics of fiscal expansion
Goods market effects
As G Y = too immediately
Then C= and I = also
Multiplier effect: at same i, Y reaches a higher level as IS shifts to the right
Financial markets effects
As Y the demand for money M =
and the ward shift in Md results in a i, but this is a movement along the curve to A’.
BlCh5

22. Effect on investment
As i increases, investment is So there are 2 opposite effects on investment
as Y increases I
as i increases I
It means that the overall expansion due to the increase in G will be by the impact of the increase in the interest rate on investment.
There is some of private investment due to the increase in government spending.
BlCh5

23. Expansionary Fiscal Policy
Y=Z Z
ZZ (G) ∆G Y Ye Y” i Ms i LM i’ i’ i i IS Md
M/P Y Ye
Y’e
BlCh5

24. Net effect of increase in G on investment
Using investmt funct
as Y increases I
as i increases I
Net effect is ambiguous
Using equil condition
as Y increases Sp
as G increases (T - G)
BlCh5

25. A fiscal expansion: G increases to 400
Problem # 5 cont.
A fiscal expansion: G increases to 400
New IS curve: Y = Y i
Y = [1/.5] ( i)
= i
Same LM curve: i = Y/
Solve: Y = (Y/ )
1.5Y = so Y = 1200
Replace in LM and we get i = .10 or 10%
BlCh5

26. Calculate the corresponding equilibrium for C & I
C = Y - .25T = = 450
I = Y i = = 350
Y = C + I + G = = 1200
Impact of fiscal expansion:
both Y and i increase.
C (a function of Y) increases too.
I increases when Y increases and decreases when i increases (ambiguous results overall).
With these data, I does not change as the two effects neutralize each other.
BlCh5

27. Monetary policy Instrument: Curve affected: Effect: LM shifts to the
Expansionary when Ms increases
LM shifts to the
Contractionary when Ms is cut
BlCh5

28. A monetary contractionLM ie A IS Y Ye
BlCh5

29. Mechanics of a monetary contraction
Open market of bonds
Suppose P=1 constant - so monetary contraction in terms is equivalent to a terms one.
Financial market effects
As Ms drops, i money market effect.
Goods market effects
As i increases, investment I = I(Y,i) is affected and Y =
BlCh5

30. Unambiguous: as Y drops and i increases, investment can only .
Effect on investment
Unambiguous: as Y drops and
i increases,
investment can only
Note that the money demand will shift to the left as Y drops dampening the extent of the increase in the interest rate on the fall of I and subsequently on the fall of Y.
BlCh5

31. A monetary contraction
M’s i Ms i IS LM i Md Ye Y
M/P
BlCh5

32. g. Monetary expansion: M/P increases to 1840
Problem #5 cont.
g. Monetary expansion: M/P increases to 1840
Same IS curve: Y = i
New LM curve: 2Y i = 1840
i = Y/ /8000
i = Y/
Solve the IS-LM system:
Y = (Y/ )
Y = Y - 460
1.5 Y = so Y = 1040
BlCh5

33. A monetary expansion reduces i and increases Y
Replace in LM:
i = 1040/ so i = .03 or 3%
Solve for C and I
C = 410 and I = 380
A monetary expansion reduces i
and increases Y
Thus C (function of Y) increases
and I (function of Y and of i) increases unambiguously.
BlCh5

34. Policy Mix 1
To maximize the expansionary (or contractionary) impact on the economy, use both expansionary monetary and expansionary fiscal policy (or both contractionary). LM i IS Y
Rational:
BlCh5

35. Policy Mix 2
To dampen the inflationary impact of an expansionary fiscal policy, use at the same time contractionary monetary policy. i LM IS Y
Rational:
BlCh5