1. Review of the previous lecture 1. Keynesian Cross  basic model of income determination  takes fiscal policy & investment as exogenous  fiscal policy has a multiplied impact on income. 2. IS curve  comes from Keynesian Cross when planned investment depends negatively on interest rate  shows all combinations of r and Y that equate planned expenditure with actual expenditure on goods & services

2. Lecture 16 Aggregate demand – I-B Instructor: Prof. Dr. Qaisar Abbas

3. Lecture Contents The LM curve, and its relation to - the Theory of Liquidity Preference How the IS-LM model determines income and the interest rate in the short run when P is fixed Policy analysis with the IS-LM Model

4. The Theory of Liquidity Preference Due to John Maynard Keynes. A simple theory in which the interest rate is determined by money supply and money demand.

5. Money Supply The supply of real money balances is fixed: M/P real money balances r interest rate

6. Money Demand Demand for real money balances: M/P real money balances r interest rate L (r )L (r )

7. Equilibrium The interest rate adjusts to equate the supply and demand for money: M/P real money balances r interest rate L (r )L (r ) r1r1

8. How the Fed raises the interest rate To increase r, Fed reduces M M/P real money balances r interest rate L (r )L (r ) r1r1 r2r2

9. CASE STUDY Volcker’s Monetary Tightening Late 1970s:  > 10% Oct 1979: Fed Chairman Paul Volcker announced that monetary policy would aim to reduce inflation. Aug 1979-April 1980: Fed reduces M/P 8.0% Jan 1983:  = 3.7% How do you think this policy change would affect interest rates?

10. Volcker’s Monetary Tightening, cont.  i < 0  i > 0 1/1983: i = 8.2% 8/1979: i = 10.4% 4/1980: i = 15.8% flexiblesticky Quantity Theory, Fisher Effect (Classical) Liquidity Preference (Keynesian) prediction actual outcome The effects of a monetary tightening on nominal interest rates prices model long runshort run

11. The LM curve Now let’s put Y back into the money demand function: The LM curve is a graph of all combinations of r and Y that equate the supply and demand for real money balances. The equation for the LM curve is:

12. Deriving the LM curve M/P r L (r, Y1 )L (r, Y1 ) r1r1 r2r2 r Y Y1Y1 r1r1 L (r, Y2 )L (r, Y2 ) r2r2 Y2Y2 LM (a) The market for real money balances (b) The LM curve

13. Understanding the LM curve’s slope The LM curve is positively sloped. Intuition: An increase in income raises money demand. Since the supply of real balances is fixed, there is now excess demand in the money market at the initial interest rate. The interest rate must rise to restore equilibrium in the money market.

14. How  M shifts the LM curve M/P r L (r, Y1 )L (r, Y1 ) r1r1 r2r2 r Y Y1Y1 r1r1 r2r2 LM 1 (a) The market for real money balances (b) The LM curve LM 2

15. Exercise: Shifting the LM curve Suppose a wave of credit card fraud causes consumers to use cash more frequently in transactions. Use the Liquidity Preference model to show how these events shift the LM curve.

16. The short-run equilibrium The short-run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods & money markets: Y r IS LM Equilibrium interest rate Equilibrium level of income

17. The Big Picture Keynesian Cross Theory of Liquidity Preference IS curve LM curve IS-LM model Agg. demand curve Agg. supply curve Model of Agg. Demand and Agg. Supply Explanation of short-run fluctuations

18. Equilibrium in the IS-LM Model The IS curve represents equilibrium in the goods market. The intersection determines the unique combination of Y and r that satisfies equilibrium in both markets. The LM curve represents money market equilibrium. IS Y r LM r1r1 Y1Y1

19. Policy analysis with the IS-LM Model Policymakers can affect macroeconomic variables with fiscal policy: G and/or T monetary policy: M We can use the IS-LM model to analyze the effects of these policies. IS Y r LM r1r1 Y1Y1

20. An increase in government purchases 1. IS curve shifts right causing output & income to rise. IS 1 Y r LM r1r1 Y1Y1 IS 2 Y2Y2 r2r2 1. 2. This raises money demand, causing the interest rate to rise… 2. 3. …which reduces investment, so the final increase in Y 3.

21. A tax cut IS 1 1. Y r LM r1r1 Y1Y1 IS 2 Y2Y2 r2r2 Because consumers save (1  MPC) of the tax cut, the initial boost in spending is smaller for  T than for an equal  G… and the IS curve shifts by 1. 2. …so the effects on r and Y are smaller for a  T than for an equal  G. 2.

22. Monetary Policy: an increase in M 1.  M > 0 shifts the LM curve down (or to the right) 2.…causing the interest rate to fall IS Y r LM 1 r1r1 Y1Y1 Y2Y2 r2r2 LM 2 3.…which increases investment, causing output & income to rise.

23. Interaction between monetary & fiscal policy Model: monetary & fiscal policy variables (M, G and T ) are exogenous Real world: Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa. Such interaction may alter the impact of the original policy change.

24. The Fed’s response to  G > 0 Suppose Congress increases G. Possible Fed responses: 1. hold M constant 2. hold r constant 3. hold Y constant In each case, the effects of the  G are different:

25. Response 1: hold M constant If Congress raises G, the IS curve shifts right IS 1 Y r LM 1 r1r1 Y1Y1 IS 2 Y2Y2 r2r2 If Fed holds M constant, then LM curve doesn’t shift. Results:

26. Response 2: hold r constant If Congress raises G, the IS curve shifts right IS 1 Y r LM 1 r1r1 Y1Y1 IS 2 Y2Y2 r2r2 To keep r constant, Fed increases M to shift LM curve right. LM 2 Y3Y3 Results:

27. Response 3: hold Y constant If Congress raises G, the IS curve shifts right IS 1 Y r LM 1 r1r1 IS 2 Y2Y2 r2r2 To keep Y constant, Fed reduces M to shift LM curve left. LM 2 Results: Y1Y1 r3r3

28. Estimates of fiscal policy multipliers from the DRI macroeconometric model Assumption about monetary policy Estimated value of  Y /  G Fed holds nominal interest rate constant Fed holds money supply constant 1.93 0.60 Estimated value of  Y /  T  1.19  0.26

29. Summary Theory of Liquidity Preference  basic model of interest rate determination  takes money supply & price level as exogenous  an increase in the money supply lowers the interest rate LM curve  comes from Liquidity Preference Theory when money demand depends positively on income  shows all combinations of r andY that equate demand for real money balances with supply

30. Summary IS-LM model  Intersection of IS and LM curves shows the unique point (Y, r ) that satisfies equilibrium in both the goods and money markets.