Ec 123 Section 5 1

Ec 123 Section 5

THIS SECTION

IS-LM Analysis– A simple model

– A slightly more sophisticated model

– Connection with our overlapping generations model?

Ec 123 Section 5 2

Keynesian demand-side explanation for recessions

• Lowered confidence in the future leads to low demand for goods and services.

• Low demand leads to unemployed resources (leakages).

• Prices are sticky; i.e, it takes quite a while for prices to change enough to absorb the unemployment.

• Note the two crucial assumptions in the story:

Demand for goods and services is volatile.

Prices are slow to adjust.

Ec 123 Section 5 3

IS-LM model

• IS-LM is a model of how the economy responds in the short run to shocks in demand as well as changes in economic policy.

• The model supposes that, in the short run, interest rates are very flexible but other prices, such as wages, are sticky and take longer to adjust.– We are implicitly assuming prices a fixed at an artificially high

price so that there is excess supply (insufficient demand) (suppliers would be willing to supply more at the same price).

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Ec 123 Section 5 4

IS-LM Terms

For the IS/LM model, terms such as money and income and savings and investment have more precise meanings than they do in informal usage. It is important to know the precise definitions.

Money = M1 = currency plus demand deposits, where demand deposits are non-interest bearing checking accounts. By the M1 definition, holding a bank savings account is not holding money.

Y = real income = real GDP, the total output of goods and services for the economy. Income is a flow, meaning, it is measured over time (ex., quarterly or annually).– Note: Income is the total goods and services the economy produces.

Money and income are not the same thing. Typically, a country uses the same stock of money several times to purchase its annual income!

Ec 123 Section 5 5

IS-LM Terms

T = total taxes paid to the government.

Y - T = disposable income.

C = expenditures devoted to consumption.

G = total expenditures by government

I = private investment = total private expenditures on plant and equipment.

S = total savings

Ec 123 Section 5 6

IS-LM Terms

It is important to recall the difference between savings and investment. Saving is the act of deciding to put income aside. Investment is the act of deciding what project to do with the savings.

Example: Suppose that, in order to raise the funds to build a new plant, a firm issues bonds. The bond-holders are saving, and the bond issuer (the firm) is investing. Alternatively, bond-holders supply savings and bond-issuers demand savings.– In equilibrium (without govt.) I = S

r = the interest rate paid by investors to compensate savers for funds. For simplicity, we assume there is one interest rate.

Ec 123 Section 5 7

Relationships between variables

I(r) is the investment function and is obviously a function of the interest rate.

• The interest rate is the price investors pay for funds, so when r goes up, I goes down.

MD(r, Y) is money demand or the demand for liquidity.• Money demand is a function of the interest rate and

income. • When the interest rate rises (all other things fixed), the

opportunity cost of holding money increases, and so money demand falls.

• When income rises (all other things fixed), agents will want to spend more, and so money demand rises.

Ec 123 Section 5 8

Deriving the IS Curve

Suppose for the moment that all income in the economy is devoted to consumption. How much consumption will consumers choose? We assume that consumption is a function of disposable income, Y - T. The following is an example:

C = 5000 + .75(Y - T)

• The coefficient on the Ye-T term can be interpreted as the marginal propensity to consume. Suppose the tax bill, T, is a fixed number.

• In equilibrium expenditures (on consumption) must equal expected income, or Yd = C, Since we are supposing C is the only use for income, Yd = Y.

Ec 123 Section 5 9

Deriving the IS Curve

Income (Y)

Yd

Expenditures

Yd=Y

C

equilibrium

Ec 123 Section 5 10

Deriving the IS Curve

Income (Y)

Yd

Yd=Y

C

•The other elements of the expenditure breakout of GDP are assumedto be autonomous, or they do not depend directly on(expected) income.

•Suppose the interest rate is fixed.

G

I(r)

Investment level is fixed given the

interest rate.

Government spending

C+I+Gequilibrium

Ec 123 Section 5 11

Deriving the IS Curve

•Now suppose that the interest rate (r) varies. When r moves, we expect that I will move in the opposite direction.

•With the change ininvestment, the goods market will move to a new equilibrium.

C+I(r0)+G

C+I(r1)+GNew equilibrium

I(r1)

Interest rate goes down from r0 to r1

Income (Y)

Yd

Yd=Y

I(r0)

Ec 123 Section 5 12

The IS curve

Y0 Output (Y) IS

Y1

Int.Rate

(r)

r0

r1

Income (Y)

Yd

Yd=Y

C+I(r0)+G

C+I(r1)+G

Interest rate goes down from r0 to r1

The IS curve gives the combinations of Y and r that produceequilibrium in the goods market.

Ec 123 Section 5 13

What determines how steep the IS curve will be?

Q0 Output (Y) Q1

r

r0

r1

Income (Y)

Yd

C+I(r0)+G

The responsiveness of I to interest rates determines the slope of the IS curve. (interest rate elasticity)

More responsive I implies a flatter IS curve.

C+I’(r1)+G

Q’1

IS

C+I(r1)+G

IS’

Ec 123 Section 5 14

The Money Market

The LM curve is determined by equilibrium in the money market.

• Assume that the supply of money MS is fixed (or inelastic) in the short run.

• Then the equilibrium will be the interest rate (the price of money) where MD = MS.

Money

MD(Y1)

MD(Y0)

MS

InterestRate

r

r0

r1

If income increases (Y1 > YO), demand for money will increase (shift). If the Fed

does not increase the money supply, interest

rates will increase (to r1).

Ec 123 Section 5 15

Deriving the LM curve

Money

LM

The LM curve gives the combinations of Y and r that produceequilibrium in the money market.

MD(Y0)

MS

Int.Rate

r

MD(Y1)

r0

r1

Output (Y)

InterestRate

r

Y0

r0

r1

Y1

Ec 123 Section 5 16

What determines how steep the LM curve will be?

M’D(Y0)

New LM curve is steeper if money demand is less sensitive to changes in interest rates.

M’D(Y1)

LM’

Money demand is less sensitive to changes in the interest rate. (less elastic)

MD(Y0)

LM

MD(Y1)

r1r1

r’1

r0r0

Money

MS

Output (Y) Y0

InterestRate

r

Y1

Ec 123 Section 5 17

Putting the IS and LM curves together

IS

Output (Y) Output (Y)

InterestRate

r

Int.Rate

rLM

Describes all possible equilibria in the goods market.

Describes all possible equilibria in the money market.

Ec 123 Section 5 18

Putting the IS and LM curves together

IS

Output (Y)

Int.Rate

rLM

Only combination of Y and r that is an

equilibrium in both the goods and money market.

r

Y0

Ec 123 Section 5 19

IS-LM and policy analysis

IS-LM analysis is good for understanding the qualitative effects of various policy changes or short term shocks to the system.

• Changes in fiscal policy (i.e., changes in G and T) will shift the IS curve.

• Changes in monetary policy will shift the LM curve.

• Shocks (exogenous events) may also shift either curve.

Ec 123 Section 5 20

The 2008 Stimulus PackageYd=Y

C+I(r0)+G’

Y1

Govt. spending shifts from G to G’.

Y0 Output (Y) IS

Int.Rate

(r)

r0

Income (Y)

Yd

C+I(r0)+G

•Expansionary fiscal policies shift the IS curve to the right.

•Contractionary fiscal policies shift the IS curve to the left.

IS’

Ec 123 Section 5 21

The 2008 Stimulus Checks (150 billion)

r

IS

Output (Y)

Int.Rate

rLM

Y

IS’

r’

Y’

Output goes up (Y’ > Y) but so does interest rates (r’ >

r).

Ec 123 Section 5 22

What determines the size of the shift?Yd=Y

C+I(r0)+G’

Y1Y0 Output (Y)

IS

Int.Rate

(r)

r0

Income (Y)

Yd

•The slope of the consumption line determines the size of the shift.

•C’ has a higher marginal propensity to consume than C so fiscal policy results in more growth. IS’

C+I(r0)+G

IS’

C’+I(r0)+G

C’+I(r0)+G’

Expansionary Fiscal Policy: G’>G

Y’1

Ec 123 Section 5 23

The Fed announces a lower interest rate target

r’ r’

Money

LM

MS

Int.Rate

r

MD(Y0)

r

Output (Y)

InterestRate

r

r

Y0

M’S

LM’

To achieve the lower target (r’) the Fed must increase the money supply.

Ec 123 Section 5 24

The Fed announces a lower interest rate target.

LM

Y’ Output (Y)

Int.Rate

r

IS

r

Y

Output goes up (Y’ > Y) but interest rates do not go

down as much as targeted.

r’

LM’

r”

•Expansionary monetary policies shift the LM curve to the right.

•Contractionary monetary policies shift the LM curve to the left.

Ec 123 Section 5 25

Relative slope of IS and LM curves determines the effectiveness of fiscal v. monetary policy

IS

LM

Output (Y)

Int.Rate

rLM

r

Y0

IS

Output (Y)

Int.Rate

r

r

Y0

Good for monetary policy:

Big growth with little change in interest rates.

LM’

r’

Y’

Good for fiscal policy:

Big growth with little crowding out.

IS’

r’

Y’

Ec 123 Section 5 26

SummaryThe IS curve:• Gives the combinations of Y and r that produce equilibrium in the goods

market.• Slopes down.• Shifts to the right when there is an increase in government spending and shifts

to the left when there is a decrease in government spending.• Shifts to the left when taxes increase. Shifts to the right when taxes decrease.• Is relatively flat in the interest elasticity of investment is relatively high. Is

relatively steep if the interest elasticity of investment is relatively low.The LM curve:• Gives the combination of Y and r that produce equilibrium in the money

market.• Slopes upward.• Shifts downward with an increase in the money supply and shifts upward with

a decrease in the money supply.• Is relatively steep if the interest elasticity of money demand is relatively low.

Is relatively flat if the interest elasticity of money demand is relatively high.