Transcript Chapter 4 -- The IS/LM Model

Chapter 4 -The IS-LM Model
Fundamental inflexibility
assumptions:
W -- inflexible
P -- inflexible
i -- flexible
Overriding theme -- The interest
rate changes as a result of
monetary policy (money supply) as
well as other factors.
The IS Curve
Re-translation of Simple
Keynesian model at equilibrium
(Investment = Saving).
A plot of equilibrium output for
various interest rates within the
market for goods and services.
Properties of the IS Curve
Downward sloping,
i  C, I  Y*
Shift variables consist of the shift
variables of the EP curve, except
for the nominal interest rate (i).
Increases in autonomous
expenditure which shift the EP
curve upward, simultaneously shift
the IS curve rightward.
Decreases in autonomous
expenditure which shift the EP
curve downward, simultaneously
shift the IS curve leftward.
The steepness or flatness of the IS
curve describes the elasticity or
responsiveness of C and I to the
nominal interest rate.
-- Steep IS curve: inelastic.
-- Flat IS curve: elastic.
Considering Additional
Behavior (Curve #2)
Extra behavior -- decisions to hold
money and financial assets.
The Demand for Money -- The
decision of how much of total
wealth should be held as money
(I.e. currency and checkable
deposits).
Fundamental Aspects -The Demand for Money
Group all assets into two
categories -- money and “bonds”.
Advantage of holding money -convenience for making desired
transactions.
Disadvantage of holding money -interest that could be earned by
holding bonds instead.
Major advantage of holding money
implies that we demand money in
real units.
The Demand for Money (L) -liquidity preference.
For a given level of real wealth, the
demand for money covers the
entire financial asset holding
decision (Walras Law).
The Demand for Money in
Real Terms (L) -- Causes
Output or Income (Y)
Y  L
The interest rate (i)
i  L
Financial Innovation (FI)
FI  L
The Supply of Real
Money (Ms/P) -- Causes
The Nominal Money Supply (MS) -the Federal Reserve’s variable for
monetary policy.
MS  (MS/P)
The (Inflexible) Price Level (P)
P  (MS/P)
The LM Curve
Depicts equilibrium in the money
market (L = M), as well as the Bond
Market (by Walras Law).
A plot of the equilibrium interest
rate for various levels of output or
income, within the money market
for a given level of the nominal
money supply.
Properties of the LM Curve
Upward sloping,
Y  L  i*
Shift variables consist of the shift
variables of the money demand
and supply curves (except for Y).
Increases in the real money
supply (MS or P) shift the LM
curve rightward.
Decreases in the real money
supply (MS or P) shift the LM
curve leftward.
The steepness or flatness of the
LM curve describes the elasticity
or responsiveness of money
demand (L) to the nominal interest
rate.
-- Steep LM curve: inelastic.
-- Flat LM curve: elastic.
Economic Policy:
IS-LM Model
Equilibrium output (Y*) takes place
where the IS and LM curves
intersect (equilibrium interest rate,
i*, as well).
Keynesian property of model 
Y* < YN, (sluggish economy)
Y* > YN, (accelerating inflation)
Y* = YN (desired state)
Types of Policy:
IS-LM Model
Fiscal Policy -- Change G0, T0, t, or
other components of autonomous
goods and services expenditure 
Shift the IS curve.
Monetary Policy -- Change the
nominal money supply (MS) 
Shift the LM curve.
Expansionary and
Contractionary Policy
Expansionary (Y* < YN) -- shifts the
appropriate curve rightward.
Contractionary (Y > YN) -- shifts
the appropriate curve leftward.
Policy Effectiveness
An effective policy is one that
obtains a large output response
for a given change -Policy effectiveness depends
upon the steepness or flatness of
the IS and LM curves.
Decomposition of Policy
Fiscal and monetary policies
change interest rates as well as
output.
This property implies that, for a
given policy,
Total Effect = Primary Effect
+ Secondary Effect.
Primary Effect -- Effect of a policy
due to factors other than how it
changes i*.
Secondary Effect -- Effect of a
policy due to how it changes i*.
Policy Effectiveness -- based upon
size of the secondary effect.