1. IS-LM Revisited Simple Income Determination Properties of IS & LM Curves Equilibrium Output & Interest Rates Economic Policy

2. (1) Simple Income Determination *Eco 1002 *Goods Market (IS) *Exogenous Interest Rate & Prices *Endogenous Income (GDP) (2) IS-LM Model *Eco 2101 (Keynesian Short-Run) *(1) + Money Market *Endogenous Income & Interest Rate (Fixed P) Endogenous Policy

3. Simple Income Determination (Eco 1001) Behavioral Assumptions: Consumption = C (y, r) y = disposable income = Y – T r = interest rate MPC = where 0 < C y < 1 Investment = I(r) Government Purchases = G Exogenous:r, P, Fiscal Policy: G, T Endogenous:Y Linear Examples

4. Equilibrium: Some Basic Results: (interest rates and GDP) (Gov. Spending Multiplier) (Tax Multiplier)

5. IS-LM Model (Eco 2101) Goods & Money Market Equilibrium IS-LM Model Exogenous: P,Fiscal Policy: G, T Monetary Policy: M s Endogenous:Y and r

6. IS and the Goods Market Goods Market Equilibrium: Y = C(y,r) + I(r) + G(IS equation) wherey = Y – T = disposable income 0< C y < 1 I r < 0 G and T are exogenous policy variables

7. Properties of IS curve: Slope*: Government spending multiplier: (shifts right) Tax Multiplier: (shifts left)

8. LM and the Money Market Real Money Demand = L(Y,r) Money Market Equilibrium: M s = P*L(Y,r)(LM equation) M s is an exogenous policy variable.

9. Properties of LM curve Slope*: Real Money Supply: (shifts right)

10. The Simple IS-LM Model - (Y,r) which solves: (IS) (LM)

11. Policy in IS-LM Model Exogenous:P Endogenous: Y, r Policy Variables:G, Ms, T Fiscal Policy (1)Government Expenditures (dG) but less than 1/(1-C y )!

12. Crowding-out effect! Effectiveness of G: If (IS Flat) or(LM verticle) then.(Complete crowding-out!) (2) Taxes (dT): dY/dT = ?, dr/dT = ?

13. Monetary Policy (dM s ):

14. Effectiveness of monetary policy: If (IS vertical) or (LM flat) Then (Ineffective Monetary Policy)

15. Liquidity Trap and Interest Rate Insensitivity Great Depression YearURi  r = i -  19308.93.6-2.66.2 193116.32.6-10.112.7 193224.12.7-9.312.0 193325.21.7-2.23.4 193422.01.07.4-6.6 193520.30.80.9-0.1 193617.00.80.20.6

16. 2008-09 Recession Jan 2007 – Jan 2010, Federal funds rate cut from 6% to 1%. i UR Jan 20075.25%4.6% Jan 20083.94%5% Jan 20090.15%7.7% Jan 20100.12%10%

17. Business Cycles in IS-LM Shocks to Consumer confidence  )  C = C(Y,r  where C  > 0  dY*/d  > 0 dr*/d  Shocks to money demand  L = L(y,r  where L   > 0  dY*/d  < 0 dr*/d 

18. Endogenous Policy Monetary/Fiscal Policy responds to economic conditions to achieve goal. Objective:dY = 0 (output stability) OR dr = 0 (interest rate stability) Exogenous:Policies - M s or G, or T Shocks –  or  Endogenous:Policies - M s or G, or T

19. Example: An increase in G and Fed’s objective is to keep r constant (prevent crowding out). Step 1:Set dr = 0 Step 2:Treat dY and dM s as endogenous, dG as exogenous. Step 3:Use Cramer’s Rule to solve for dY/dG and dM s /dG. Suppose instead Fed wanted to keep output stable (dY = 0). Find dr/dG and dM s /dG.

20. Evaluation of Simple Keynesian IS- LM Models Provided reasonable explanation of business cycles. Guides policymakers on stabilizing economic fluctuations. Can be applied easily to think about current events.

21. Shortcomings Criticisms of IS-LM Model: (1)Emphasis on aggregate demand. (2)Static Model. (3)Lack of solid microeconomic foundations. Lucas Critique on Policy Evaluation Examples: Consumption, Phillips Curve

22. Modern Macro Dynamics Expectations (rational) Microeconomic Foundations Most modern macro models (New Classical and New Keynesian) have these features.