IS – LM model Copyright © 2004 South-Western Context • This chapter develops the IS-LM model, the theory that yields the aggregate demand curve • We focus on the short run and assume the price level is fixed • This chapter focus on the closed-economy case Copyright © 2004 South-Western The Keynesian Cross • A simple closed economy model in which income is determined by expenditure (due to J.M Keynes) • Notation: I = planned investment E = C + I + G = planned expenditure Y = real GDP = actual expenditure • Difference between actual & planned expenditure: unplanned inventory investment Copyright © 2004 South-Western Elements of the Keynesian Cross consumption function: govt policy variables: for now, planned investment is exogenous: planned expenditure: C C (Y T ) G G , T T I I E C (Y T ) I G Equilibrium condition: Actual expenditure Planned expenditure Y E Copyright © 2004 South-Western Graphing planned expenditure E planned expenditure E =C +I +G MPC income, output, Y Copyright © 2004 South-Western Graphing the equilibrium condition E E =Y planned expenditure 45º income, output, Y Copyright © 2004 South-Western The equilibrium value of income E E =Y planned expenditure E =C +I +G income, output, Y Equilibrium income Copyright © 2004 South-Western The IS curve A graph of all combinations of r and Y that result in goods market equilibrium, i.e actual expenditure (output) = planned expenditure The equation for the IS curve is: Y C (Y T ) I (r ) G Copyright © 2004 South-Western Deriving the IS curve E =Y E r I E Y E =C +I (r2 )+G E =C +I (r1 )+G I r Y1 Y Y2 r1 r2 IS Y1 Y2 Y Copyright © 2004 South-Western Why the IS curve is negatively sloped • A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending (E ) • To restore equilibrium in the goods market, output (a.k.a actual expenditure, Y ) must increase IS is negative: increase (decrease) r decrease (increase) I decrease (increase) Y Copyright © 2004 South-Western 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 Copyright © 2004 South-Western The Fed’s response to G > • Suppose Congress increases G • Possible Fed responses: hold M constant hold r constant hold Y constant • In each case, the effects of the G are different: Copyright © 2004 South-Western Response 1: hold M constant If Congress raises G, the IS curve shifts right If Fed holds M constant, then LM curve doesn’t shift r LM1 r2 r1 IS2 IS1 Results: Y Y Y1 Y1 Y2 Y r r2 r1 Copyright © 2004 South-Western Response 2: hold r constant If Congress raises G, the IS curve shifts right r To keep r constant, Fed increases M to shift LM curve right r2 r1 LM1 IS2 IS1 Results: Y Y Y1 LM2 Y1 Y2 Y3 Y r Copyright © 2004 South-Western Response 3: hold Y constant If Congress raises G, the IS curve shifts right To keep Y constant, Fed reduces M to shift LM curve left LM2 LM1 r r3 r2 r1 IS2 IS1 Results: Y Y1 Y2 Y r r3 r1 Copyright © 2004 South-Western Estimates of fiscal policy multipliers from the DRI macroeconometric model Estimated value of Y / G Estimated value of Y / T Fed holds money supply constant 0.60 0.26 Fed holds nominal interest rate constant 1.93 1.19 Assumption about monetary policy Copyright © 2004 South-Western Shocks in the IS-LM Model IS shocks: exogenous changes in the demand for goods & services Examples: • stock market boom or crash change in households’ wealth C • change in business or consumer confidence or expectations I and/or C Copyright © 2004 South-Western Shocks in the IS-LM Model LM shocks: exogenous changes in the demand for money Examples: • a wave of credit card fraud increases demand for money • more ATMs or the Internet reduce money demand Copyright © 2004 South-Western Deriving the AD curve Intuition for slope of AD curve: P (M/P ) LM shifts left r I Y r LM(P2) LM(P1) r2 r1 IS P Y2 Y1 Y P2 P1 AD Y2 Y1 Y Copyright © 2004 South-Western Monetary policy and the AD curve The Fed can increase aggregate demand: M LM shifts right r LM(M1/P1) r1 r2 LM(M2/P1) IS r I P Y at each value of P P1 Y1 Y1 Y2 Y2 Y AD2 AD1 Y Copyright © 2004 South-Western Fiscal policy and the AD curve Expansionary fiscal policy (G and/or T ) increases agg demand: r LM r2 r1 IS2 T C IS1 IS shifts right P Y1 Y2 Y Y at each value P1 of P Y1 Y2 AD2 AD1 Y Copyright © 2004 South-Western IS-LM and AD-AS in the short run & long run The force that moves the economy from the short run to the long run is the gradual adjustment of prices In the short-run equilibrium, if then over time, the price level will Y Y rise Y Y fall Y Y remain constant Copyright © 2004 South-Western 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 you think this policy change would affect interest rates? Copyright © 2004 South-Western Volcker’s Monetary Tightening, cont The effects of a monetary tightening on nominal interest rates model short run long run Liquidity Preference Quantity Theory, Fisher Effect (Keynesian) (Classical) prices sticky flexible prediction i > i < actual outcome 8/1979: i = 10.4% 4/1980: i = 15.8% 1/1983: i = 8.2% Copyright © 2004 South-Western 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 Copyright © 2004 South-Western ... model r S2 r S1 r2 r2 r1 r1 I (r ) S, I IS Y2 Y1 Y Copyright © 2004 South-Western Fiscal Policy and the IS curve • We can use the IS- LM model to see how fiscal policy (G and T ) can affect aggregate...Context • This chapter develops the IS- LM model, the theory that yields the aggregate demand curve • We focus on the short run and assume the price level is fixed • This chapter focus on... balances (b) The LM curve r LM r2 r2 L ( r , Y2 ) r1 r1 L ( r , Y1 ) M1 P M/P Y1 Y2 Y Copyright © 2004 South-Western Why the LM curve is upward-sloping • An increase in income raises money demand