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Introduction to MacroeconomicsTOPIC 4: The IS-LM ModelAnnaı̈g MorinCBS - Department of EconomicsAugust 2013Introduction to MacroeconomicsTOPIC 4: The IS-LM Model

The IS-LM ModelIn topic 2 The Goods Market, we isolated the goods market fromthe financial one by assuming that investment was not a functionof the interest rate.In topic 3 The Financial Market, we studied the interest rate andhow it is determined on the financial market.Now, lets go back to the goods market and see what changes withthe new assumption that investment is a function of the interestrate. Lets study the goods and the financial market together.Introduction to MacroeconomicsTOPIC 4: The IS-LM Model

The IS-LM ModelRoad map:The goods market: the IS curveThe financial market: LM curveEquilibrium: IS-LMFiscal and monetary policiesIntroduction to MacroeconomicsTOPIC 4: The IS-LM Model

1. The goods marketIntroduction to MacroeconomicsTOPIC 4: The IS-LM Model

1. The goods market1. The goods market1.1. What we remember from Topic 21.2. Investment1.3. Determining output1.4. The IS relation1.5. Shifts of the IS curveIntroduction to MacroeconomicsTOPIC 4: The IS-LM Model

1.1. The goods market - What we rememberRemember topic 2 The Goods Market:Demand for goods: C (YD ) I Gwhere YD Y T is the disposable incomeSupply of goods: YEquilibrium: Y C (Yd) I GIntroduction to MacroeconomicsTOPIC 4: The IS-LM Model

1.2. The goods market - InvestmentInvestment is not constant. It depends primarily on two factors:Production ( )Interest rate (-):the higher the interest rate, the more expensive it is to borrowin order to invest, the lower the level of investment.Investment function: I I (Y , i) {z }( , )Introduction to MacroeconomicsTOPIC 4: The IS-LM Model

1.3. The goods market - Determining outputThe demand for goods is: C (Y , T ) I (Y , i) G {z } {z }( , )( , ), the demand for goods is increasing in Y (income/production).Introduction to MacroeconomicsTOPIC 4: The IS-LM Model

1.3. The goods market - Determining outputFigure: Equilibrium in the goods marketIntroduction to MacroeconomicsTOPIC 4: The IS-LM Model

1.4. The goods market - IS relationEquilibrium: Y C (Y , T ) I (Y , i) G {z } {z }( , )( , )This equilibrium condition is called the IS relation.Introduction to MacroeconomicsTOPIC 4: The IS-LM Model

1.4. The goods market - IS relationFigure: Effect on the equilibrium level of production of an increase in theinterest rateIntroduction to MacroeconomicsTOPIC 4: The IS-LM Model

1.4. The goods market - IS relationIf the interest rate increases, investment drops which pushes downthe demand for goods. The equilibrium level of output is lower., Decreasing relation between the interest rate and equilibriumoutput.Introduction to MacroeconomicsTOPIC 4: The IS-LM Model

Figure: Construction of the IS curveIntroduction to MacroeconomicsTOPIC 4: The IS-LM Model

1.4. The goods market - IS relationThe downward-sloping IS curve represents the negative relationbetween the interest rate and the equilibrium output.All the points on this curve represents an equilibrium on the goodsmarket.Introduction to MacroeconomicsTOPIC 4: The IS-LM Model

1.5. The goods market - Shifts of the IS curveWhat happens if taxes increase?Disposable income drops, consumption drops, demand dropsSupply must drop too to maintain the equilibrium.For any level of interest rate, the corresponding level ofequilibrium output is now lower, leftward shift of the IS curve.Introduction to MacroeconomicsTOPIC 4: The IS-LM Model

1.5. The goods market - Shifts of the IS curveFigure: Effect on the IS curve of an increase in taxesIntroduction to MacroeconomicsTOPIC 4: The IS-LM Model

1.5. The goods market - Shifts of the IS curveAny change (decrease in government consumption, increase intaxes, decrease in consumer confidence - proxied by c0 ) that, for agiven interest rate, decreases the demand for goods creates a shiftof the IS curve to the left.Symmetrically, any change (increase in government consumption,decrease in taxes, increase in consumer confidence - proxied by c0 )that, for a given interest rate, increases the demand for goodscreates a shift of the IS curve to the right.Introduction to MacroeconomicsTOPIC 4: The IS-LM Model

2. The financial marketIntroduction to MacroeconomicsTOPIC 4: The IS-LM Model

2. The financial market2. The financial market2.1. The LM relation2.2. Shifts of the LM curveIntroduction to MacroeconomicsTOPIC 4: The IS-LM Model

2.1. The financial market - LM relationRemember topic 3 The Financial Market:Equilibrium: M S M D M YL(i)Now lets talk in real terms (because we want an analysis in terms ofgoods), We divide by the price level (GDP deflator, denoted by P):Equilibrium:MP YL(i)This equilibrium condition is called the LM relation.Introduction to MacroeconomicsTOPIC 4: The IS-LM Model

2.1. The financial market - LM relationFigure: Effect on the interest rate of an increase in incomeIntroduction to MacroeconomicsTOPIC 4: The IS-LM Model

2.1. The financial market - LM relationIf income increases, the demand for money increases at any giveninterest rate. Given that the supply of money is fixed, the interestrate must increase to lower the demand for money and maintainthe equilibrium., Increasing relation between the interest rate and output.Introduction to MacroeconomicsTOPIC 4: The IS-LM Model

2.1. The financial market - LM relationFigure: Construction of the LM curveIntroduction to MacroeconomicsTOPIC 4: The IS-LM Model

2.1. The financial market - LM relationThe upward-sloping LM curve represents the positive relationbetween the interest rate and output.All the points on this curve represents an equilibrium on thefinancial market.Introduction to MacroeconomicsTOPIC 4: The IS-LM Model

2.2. The financial market - Shifts of the LM curveWhat happens if the nominal money supply increases?Real money supply goes upDemand for money should go up too, to maintain equilibrium:the interest rate must decreaseFor any level of output, the corresponding level of interestrate is now lower, downward shift of the LM curve.Introduction to MacroeconomicsTOPIC 4: The IS-LM Model

2.2. The financial market - Shifts of the LM curveFigure: Effect on the LM curve of an increase in money supplyIntroduction to MacroeconomicsTOPIC 4: The IS-LM Model

2.2. The financial market - Shifts of the LM curveAn increase in the money supply causes the LM curve to shiftdown.Symmetrically, a decrease in the money supply causes the LMcurve to shift up.Introduction to MacroeconomicsTOPIC 4: The IS-LM Model

3. The IS-LM modelIntroduction to MacroeconomicsTOPIC 4: The IS-LM Model

3. The IS-LM model3. The IS-LM model3.1. An equilibrium concept3.2. Fiscal policy3.3. Monetary policy3.4. Fiscal and monetary policies3.5. Policy mixIntroduction to MacroeconomicsTOPIC 4: The IS-LM Model

3.1. The IS-LM model - An equilibrium conceptIS relation:the supply of goods must be equal to the demand for goodsLM relation:the supply of money must be equal to the demand for moneyIntroduction to MacroeconomicsTOPIC 4: The IS-LM Model

3.1. The IS-LM model - An equilibrium conceptFigure: The IS-LM modelIntroduction to MacroeconomicsTOPIC 4: The IS-LM Model

3.2. The IS-LM model - Fiscal policyFiscal policy:Fiscal contraction (or fiscal consolidation): decrease in thebudget deficit G Tdecrease in government spendingincrease in taxesFiscal expansion: increase in the budget deficit G Tincrease in government spendingdecrease in taxesIntroduction to MacroeconomicsTOPIC 4: The IS-LM Model

3.2. The IS-LM model - Fiscal policyWhat happens when taxes increase?Leftward shift of the IS curve. Why?No shift of the LM curve. Why?The increase in taxes shifts the IS curve. The LM curve does notshift, the economy moves along the LM curve.Introduction to MacroeconomicsTOPIC 4: The IS-LM Model

3.2. The IS-LM model - Fiscal policyWhen taxes increase:Consumption goes down, leading to a decrease inoutput/income.The decrease in income reduces the demand for money. Giventhat the supply of money is fixed, the interest rate mustdecrease to push up the demand for money and maintain theequilibrium.Introduction to MacroeconomicsTOPIC 4: The IS-LM Model

3.2. The IS-LM model - Fiscal policyNB: the decrease in output is limited by the positive effect of adecrease in the interest rate on investment (even though we don’tknow if investment increases or decreases).Introduction to MacroeconomicsTOPIC 4: The IS-LM Model

3.2. The IS-LM model - Fiscal policyFigure: The effects of an increase in taxesIntroduction to MacroeconomicsTOPIC 4: The IS-LM Model

3.3.The IS-LM model - Monetary policyMonetary policy:Monetary contraction (or monetary tightening): decreasein the money supplyMonetary expansion: increase in the money supplyIntroduction to MacroeconomicsTOPIC 4: The IS-LM Model

3.3. The IS-LM model - Monetary policyWhat happens when the money supply increases?No shift of the IS curve. Why?Downward shift of the LM curve. Why?The increase in taxes shifts the LM curve. The IS curve does notshift, the economy moves along the IS curve.Introduction to MacroeconomicsTOPIC 4: The IS-LM Model

3.3. The IS-LM model - Monetary policyWhen money supply increases:To maintain the equilibrium, the demand for money should goup. For that to happen, the interest rate must decrease.The decrease in the interest rate favor investment, demand forgoods and equilibrium output.Introduction to MacroeconomicsTOPIC 4: The IS-LM Model

3.3. The IS-LM model - Monetary policyNB: the decrease in the interest rate is limited by the positiveeffect of an increase in output on investment, and therefore onoutput.Introduction to MacroeconomicsTOPIC 4: The IS-LM Model

3.3. The IS-LM model - Monetary policyFigure: The effects of an increase in money supplyIntroduction to MacroeconomicsTOPIC 4: The IS-LM Model

3.4. The IS-LM model - Fiscal and monetary policiesFigure: The effects of fiscal and monetary policyIntroduction to MacroeconomicsTOPIC 4: The IS-LM Model

3.5. The IS-LM model - Policy MixThe combination of monetary and fiscal policies is called thepolicy mix.Bigger impact on outputAllows a change in the output level without a too largechange in the interest rate.Introduction to MacroeconomicsTOPIC 4: The IS-LM Model

3.5. The IS-LM model - Policy MixFigure: The policy mix against the recession of 2001Introduction to MacroeconomicsTOPIC 4: The IS-LM Model

ConclusionWe studied the goods and financial markets separately andtogether. But until now, we made a big assumption: we ignoredthe possible interactions between an economy and the rest of theworld, on the goods and the financial markets.Now, lets relax this assumption and analyze an open economy.Introduction to MacroeconomicsTOPIC 4: The IS-LM Model

2.2. The nancial market - Shifts of the LM curve What happens if the nominal money supply increases? Real money supply goes up Demand for money should go up too, to maintain equilibrium: the interest rate must decrease For any level of output, the corresponding level of interest rate is now lower,!downward shift of the LM curve.