Review of IS-LM - Isaac Baley
Transcript of Review of IS-LM - Isaac Baley
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Review of IS-LM Closed Economy
Macroeconomics I 22104, Fall 2017Isaac Baley
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Long-, medium-, and short-run
Long-run What affects the trend?
Short-run Temporary deviations from trend - Expansions and contractions
Medium-run When economy is at the trend - We normalize trend to a constant - Call it “natural level” of Y or Yn
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• A tool to think about short-run economic fluctuations
✴ Short run = Prices are fixed
✴ The IS equation: equilibrium in the goods market
✴ The LM equation: equilibrium in the financial market
✴ Together, determine GDP (Y) and interest rate (i)
• Study effects of fiscal and monetary policy choices
A formal framework: IS-LM Model
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Gross Domestic Product (GDP)
Output (Value of Final Goods
and Services Produced)
Income (Value of payments to
labor, capital and profits)
=Y ≡
IS Equation: Equilibrium in Goods Market
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Gross Domestic Product (GDP)
Output (Value of Final Goods
and Services Produced)
Income (Value of payments to
labor, capital and profits)
=Y ≡
IS Equation: Equilibrium in Goods Market
Demand for Goods (Z)
Z =C Y −T( )+ I Y,i( )+G
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Gross Domestic Product (GDP)
Output (Value of Final Goods
and Services Produced)
Income (Value of payments to
labor, capital and profits)
=Y ≡
IS Equation: Equilibrium in Goods Market
Demand for Goods (Z)
Z =C Y −T( )+ I Y,i( )+G
Private Consumption (depends on after-tax income)
(+)
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Gross Domestic Product (GDP)
Output (Value of Final Goods
and Services Produced)
Income (Value of payments to
labor, capital and profits)
=Y ≡
IS Equation: Equilibrium in Goods Market
Demand for Goods (Z)
Z =C Y −T( )+ I Y,i( )+G
Investment (depends on income and interest rate)
(+, -)
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Gross Domestic Product (GDP)
Output (Value of Final Goods
and Services Produced)
Income (Value of payments to
labor, capital and profits)
=Y ≡
IS Equation: Equilibrium in Goods Market
Demand for Goods (Z)
Z =C Y −T( )+ I Y,i( )+G
Government Expenditure
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Gross Domestic Product (GDP)
Output (Value of Final Goods
and Services Produced)
Income (Value of payments to
labor, capital and profits)
=Y ≡
IS Equation: Equilibrium in Goods Market
Demand for Goods (Z)
Z =C Y −T( )+ I Y,i( )+G
Equilibrium in Market for Goods (Demand = Production) Z =Y
( ) ( ),Y C Y T I Y i G= − + +IS CURVE:
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( ) ( ): ,ZZ Z C Y T I Y i G= − + +
A: (Y,i )
IS Equation: Equilibrium in Goods Market
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( ) ( ): ,ZZ Z C Y T I Y i G= − + +
( ) ( )' : , ' 'ZZ Z C Y T I Y i G i i= − + + >
A: (Y,i ) A' : (Y ',i ')
IS Equation: Equilibrium in Goods Market
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( ) ( ): ,ZZ Z C Y T I Y i G= − + +
( ) ( )' : , ' 'ZZ Z C Y T I Y i G i i= − + + >
A: (Y,i ) A' : (Y ',i ')
IS Equation: Equilibrium in Goods Market
In the GOODS market, there is a NEGATIVE relationship between
OUTPUT and INTEREST RATE
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Supply of Money (by the Central Bank)
Demand for Money
SM
( )dM PYL i=
( ): Price Level : Real Income : Liquidity PreferenceP Y L i
LM Equation: Equilibrium in Financial Market
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Supply of Money (by the Central Bank)
Demand for Money
SM
( )dM PYL i=
( ): Price Level : Real Income : Liquidity PreferenceP Y L i
LM Equation: Equilibrium in Financial Market
Key assumption: Prices are constant in the Short-Run (but NOT in the transition to the Medium-Run)
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Supply of Money (by the Central Bank)
Demand for Money
SM
( )dM PYL i=
( ): Price Level : Real Income : Liquidity PreferenceP Y L i
LM Equation: Equilibrium in Financial Market
i : Interest Rate Opportunity cost of holding money rather than Bonds
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Supply of Money (by the Central Bank)
Demand for Money
SM
( )dM PYL i=
( ): Price Level : Real Income : Liquidity PreferenceP Y L i
LM Equation: Equilibrium in Financial Market
Equilibrium in Market for Money (Demand = Supply)
d SM M=
( )M PYL i= ( )or M YL iP=
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( ):d
d MM YL iP
=
:S dM MAP P
=
( ): d
d MM Y L i Y YP
ʹ ʹ ʹ= >
:S dM MAP P
ʹʹ =
LM Equation: Equilibrium in Financial Market
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( ):d
d MM YL iP
=
:S dM MAP P
=
( ): d
d MM Y L i Y YP
ʹ ʹ ʹ= >
:S dM MAP P
ʹʹ =
LM Equation: Equilibrium in Financial Market
In the MONEY market, there is a POSITIVE
relationship between OUTPUT and INTEREST RATE
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( ) ( ),Y C Y T I Y i G= − + +
MP=YL i()
IS-LM Model Joint equilibrium in Goods Market and Financial Market
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Point A: Income Y and interest rate i at which both the market for goods and the market for money are in equilibrium.
( ) ( ),Y C Y T I Y i G= − + +
MP=YL i()
IS-LM Model Joint equilibrium in Goods Market and Financial Market
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( ) ( ),Y C Y T I Y i G= − + +
MP=YL i()
IS-LM Model Joint equilibrium in Goods Market and Financial Market
Important Distinction: movements along a curve VS. shifts of a curve
Y, i M, T, G, P, C0, I0
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Short-Run Medium-Run
Fiscal:
Monetary:
Very Powerful
M ↑⇒Y↑, r ↓
- No effect on Y - Only on r and PG↑⇒Y↑, r ↑
Fiscal and Monetary Policy Closed Economy
Very Powerful - No effect on Y and r - Only on P
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Short-Run Medium-Run
Fiscal:
Monetary:
Very Powerful
M ↑⇒Y↑, r ↓
- No effect on Y - Only on r and PG↑⇒Y↑, r ↑
Fiscal and Monetary Policy Closed Economy
Very Powerful - No effect on Y and r - Only on P
Q2
Q3
Fiscal austerity + Monetary expansion
Consumer confidence