1

Goods and of Financial Market : The IS-LM Model

The Goods Market and The IS Relation

Y = C (Y-T) + I + G

Investment, Sales, and The Interest Rate

I = I (Y, i)

(+, -)

Where : Y = Production

i = Interest rate

2

The IS Curve

Y = C (Y-T) + I (Y, i) + G

The supply of goods (the left side) must be equal to the demand for goods (the right side)

3

The Effects of an Increase in The Interest rate on Output

Demand, zFor interest rate, i

A’

A

Y’ Y Output, Y

ZZ

ZZ’

For interest rate I’>i

4

The Derivation of the IS Curve

A’

A

Y’ Y Output, Y

ZZ

ZZ’

Output, Y

Interest rate, i

i’

i

Y’ Y

IS curve

A’

A

5

The Shifts in the IS Curve

Output, Y

Interest rate, i

IS ( For taxes T)

IS ( for T’>T)

i

Y’ Y

6

Financial Markets and The LM Relation

MS = M d

M = $ YL (i)

Variable M on The left side is the nominal money stock

M/P = Y L (i) ………….. LM Relation

7

The effects of an increase in Income on the interest rate

M d’ (for Y’> Y)

M d (for Income Y)

A

A’i’

i

Interest rate, i

M/P Real Money, M/P)

8

The Derivation of The LM Curve

Income, Y

M d’ (for Y’> Y)

M d (for Income Y)

A’

A A

A’

M/P (Real Money, M/P)

i i

I’ I’

Y Y’

Interest rate, i Interest rate, i

LM

9

Shifts in The LM Curve

Income, Y

Interest rate, i

i’

i

Y

LM (for M/P)

LM ‘ (for M’/P > M/P)

An Increase in Money

10

The IS-LM Model : Exercises

IS Relation Y = C(Y-T)+I(Y, i) + G

LM Relation M/P = Y L( i )

11

Equilibrium in Goods Market (IS)

Interest rate, i Equilibrium in Financial Market (LM)

Income, YY

i

The IS-LM Model

12

Fiscal Policy, Activity, and The Interest Rates

Decrease in G-T

Fiscal contraction/ Fiscal Consolidation

Increase in G-T Fiscal Expansion

13

In answering this or any question about the effects of Changes in policy, always follow these three steps :

1.Ask how this change affects good and financial market equilibrium relations , how its shifts the IS or/and the LM Curve

2.Characterize the effects of these shifts on the equilibrium

3.Describe the effects in the words

14

How The Increase in Taxes

The Increase in taxes affects equilibrium in the goods market (IS)

The increase in taxes affects decreases consumption ( because people have less disposable income ) and through the multiplier, decreases output

What Happens to the LM Curve ? nothing

15

The effects of an Increase in Taxes

IS (for T)

IS’ (for T’> T)

Output, Y

Interest rate, i

i’

i

LM

Y’ Y

An Increase in taxes shifts the IS curve to the left, and leads to a decrease in equilibrium output and the equilibrium interest rate

16

Monetary Policy, Activity, and The Interest Rates

Increase in Money (M)

Monetaryexpansion

Decrease in Money (M)

Monetary Contraction/Monetary Tightening

1817

How The Central Bank Increases Nominal Money, through open market operation (Price level is fixed)

The Increase in Nominal money affects equilibrium in the Financial market (LM)

An increase in money shifts the LM down

What Happens to the IS Curve ? Nothing

18

The effects of a monetary Expansion

IS

LM (for M/P)

LM’ (for M’/P) > M/P)

Interest rate, i

Output, YY Y’

i

I’

A monetary expansion leads to higher output and a lower interest rate

19

 Shifts in IS

Shifts in LM

Movement in Output

Movement in Interest Rate

Increase in Taxes Left None down down

Decrease in taxes Right None Up Up

Increase in Spending Right None Up Up

Decrease in Spending Left None down down

Increase in money None down Up down

Decrease in money None Up down Up

The Effects of Fiscal and Monetary Policy

20

Using a Policy Mix

o Some times monetary and fiscal policies is used to offset the adverse on the demand for goods of fiscal contraction

o Some times the monetary-fiscal mix emerges from tensions or even disagreements between the government (which is in charge of fiscal policy) and the central bank (which is in charge of monetary policy)

21

Table : Selected Macro Variables for USA, 1991-1998

  1991 1992 1993 1994 1995 1996 1997 1998

Budget Surplus (% of GDP)                

(minus sign : deficit) -3.3 -4.5 -3.85 -2.7 -2.4 -1.04 -0.3 0.8

GDP Growth (%) -0.9 2.7 2.3 3.4 2 2.7 3.9 3.7

Interest Rate (%) 7.3 5.5 3.7 3.3 5 5.6 5.2 4.8

Source : Bureau of economic Analysis

22

Deficit Reduction and Monetary Expansion

Output, Y

Interest rate, i

IS’

IS

LM

LM’

A

A’

Bi

I’

Y

The Right Combination of deficit reduction and monetary expansion can achieve a reduction in the deficit without adverse effects on output

23

Adding Dynamics

Source of dynamics in goods market :

a)Production adjusts slowly to demand

b)Demand (consumption and investment) adjusts slowly to income (production)

Slow adjustment of Y in goods market

Fast adjustment of i in financial market

24

Interest rate, i

Output, Y

AB

YAYB

iA

IS’

IS

Output decreases slowly

Output Increases slowly

YA

A

B

LM’

LM

iA

iB

Output, Y

Interest rate, i

Goods Market Financial Market

Interest rateAdjust

Instantaneously

25

Output, Y

Interest rate, i

IS

LM’

LM

A

A’

A’’

i’

i’’

i

YY’

The Dynamic effects of a Monetary contraction

A monetary contraction leads To an increase in the interestRate. The Increase in the Interest rate leads, over timeTo decline in output

26

Monetary and Fiscal Policy : an Example

Consider the following IS-LM Model :

C = 200 + 0.25 YD

I = 150 + 0.25 Y – 1000 I

G = 250

T = 200

(M/P) d = 2Y- 8000 i

M/P = 1,600

27

1. Derive the equation for the IS curve

2. Derive the equation for LM curve

3. Solve for equilibrium real output

4. Solve equilibrium interest rate

5. Solve for equilibrium values of C and I

6. Now Suppose that the money supply increases to M/P = 1840. Solve Y, i, C and explain in words the effects of expansionary monetary policy

7. Set M/P equal its initial value of 1600, Now suppose that government spending increase to G = 400. Summarize the effects of expansionary fiscal policy on Y, i and C. and why if government spending decrease to G = 100