Transcript Chapter 5: Goods and Financial Markets: The IS

CHAPTER
5
Goods and
Financial Markets:
The IS-LM Model
Prepared by:
Fernando Quijano and Yvonn Quijano
And Modified by Gabriel Martinez
How are Output and the Interest
Rate Jointly Determined in the Short
Run?
 Output and the interest rate are determined by
simultaneous equilibrium in the goods and money
markets.
– In the short run, we assume that production responds to
demand without changes in price (i.e., price is fixed), so
output is determined by demand.
 The determination of output is the fundamental
issue in macroeconomics.
– The interest rate affects output (through investment) and
output affects the interest rate (through money
demand), so it is necessary to consider the
simultaneous determination of output and the interest
rate.
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5-1
The Goods Market
and the IS Relation
 Equilibrium in the goods market exists
when production, Y, is equal to the
demand for goods, Z.
 In the simple model developed in chapter
3, the interest rate did not affect the
demand for goods. The equilibrium
condition was given by:
Y  C(Y  T )  I  G
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Investment, Sales,
and the Interest Rate
 In this chapter, we capture the effects
of two factors affecting investment:
– The level of sales (+)
– The interest rate (-)
I  I (Y , i )
 
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The Determination of Output
I  I (Y , i )
 Taking into account the investment relation
above, the equilibrium condition in the
goods market becomes:
Y  C(Y  T )  I (Y , i )  G
– Notice we don’t assume that the relation
between C and Y, or between I and Y, has to be
linear.
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The Determination of Output
Equilibrium in the Goods
Market
The demand for goods is
an increasing function of
output. Equilibrium
requires that the demand
for goods be equal to
output.
Note: The ZZ line is flatter than the 45° line because the econometric
evidence tells us that increases in consumption and investment do not
exceed the corresponding increase in output.
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Olivier Blanchard
Consumption on GDP
10000.0
C
 0.69
Y
8000.0
6000.0
y = 0.6942x - 106.02
2
R = 0.9965
4000.0
2000.0
0.0
0.0
2000.0 4000.0 6000.0 8000.0 10000.0 12000.0
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Investment on GDP
2000.0
y = 0.1619x - 128.41
2
R = 0.9748
I
 0.16
Y
1500.0
1000.0
500.0
0.0
0.0
-500.0
2000.0
4000.0
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6000.0
8000.0
Macroeconomics, 3/e
10000.0
12000.0
Olivier Blanchard
Change of Consumption on Change of GDP
0.15
0.1
y = 0.2857x + 0.0234
2
R = 0.2296
0.05
0
-0.15
-0.1
-0.05 0
-0.05
0.05
0.1
0.15
0.2
0.25
-0.1
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Change of Investment on Change of GDP
1
0.8
0.6
0.4
y = 0.4868x + 0.0332
R2 = 0.0217
0.2
0
-0.15
-0.1
-0.05
0
0.05
0.1
0.15
0.2
0.25
-0.2
-0.4
-0.6
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Deriving the IS Curve
The Effects of an
Increase in
the Interest Rate on
Output
An increase in the
interest rate decreases
the demand for goods
at any level of output.
By the multiplier effect,
output falls.
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Deriving the IS Curve






In Words:
i rises 
Investment falls 
The ZZ curve shifts down 
Equilibrium output falls.
 In the goods market, there is an inverse
relation between i and Y.
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Deriving the IS
Curve
The Derivation of the IS
Curve
Equilibrium in the
goods market implies
that an increase in
the interest rate leads
to a decrease in
output. The IS curve
is downward sloping.
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Olivier Blanchard
Shifts of the IS Curve
Y  C(Y  T )  I (Y , i )  G
Shifts of the IS
Curve
An increase in
taxes shifts the IS
curve to the left.
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Shifts of the IS Curve
 The IS curve shifts to the right if:
– Taxes fall,
– Government spending rises,
– Autonomous Investment rises,
 (that is, I rises for reasons besides i or Y)
– Autonomous Consumption rises.
 It does not shift when i or Y change.
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Every point on the IS curve is an
equilibrium for the goods market.
Z
ZZ,
High
interest
rate
Z
ZZ,
Medium Interest Rate
Interest, i
Y
Y
Z
ZZ,
Low Interest Rate
Y
Income, Y
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Every point on the IS curve is an
equilibrium for the goods market.
Interest, i
Z
ZZ,
Medium Interest Rate
Y
IS’ (high consumer confidence)
IS (low consumer confidence)
Income, Y
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Olivier Blanchard
5-2
Financial Markets
and the LM Relation
 The interest rate is determined by the
equality of the supply of and the demand for
money:
M  PYL(i)
M = nominal money stock
PYL(i) = demand for money
PY = $Y = nominal income
i = nominal interest rate
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Real Money, Real Income,
and the Interest Rate
 The LM relation: In equilibrium, the real money
supply is equal to the real money demand, which
depends on real income, Y, and the interest rate, i:
M
 YL(i )
P
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Deriving the LM Curve
 Suppose Real Income increases:
 Y rises 
 People demand more money for
transactions 
 Md shifts out.
 If Ms is vertical,  i rises …
 … until the quantity of money demanded
equals the quantity of money supplied,
which is fixed.
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Deriving the LM Curve
The Effects of an
Increase in Income on
the Interest Rate
An increase in income
leads, at a given
interest rate, to an
increase in the
demand for money.
Given the money
supply, this leads to
an increase in the
equilibrium interest
rate.
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Deriving the LM Curve
Equilibrium in financial markets implies that an increase in
income leads to an increase in the interest rate. The LM curve
is upward-sloping.
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Olivier Blanchard
Shifts of the LM Curve
Shifts of the LM
Curve
If the Central
Bank
increases the
money supply,
the LM curve
shifts down.
The LM curve shifts in response to any factor that affects
the money market, except i or Y.
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Olivier Blanchard
interest, i
Every point on the LM curve is an
equilibrium for the money market.
Ms
Md, High income
Ms
Interest, i
interest, i
M/P
Md, Medium
income
interest, i
M/P
Ms
Md, Low income
M/P
Income, Y
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Olivier Blanchard
Putting the IS and the
5-3
LM Relations Together
The IS-LM Model
Equilibrium in the goods market
implies that an increase in the
interest rate leads to a decrease
in output.
Equilibrium in financial markets
implies that an increase in
output leads to an increase in
the interest rate.
When the IS curve intersects the
LM curve, both goods and
financial markets are in
equilibrium.
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IS relation: Y  C(Y  T )  I (Y , i )  G
LM relation:
Macroeconomics, 3/e
M
 YL(i )
P
Olivier Blanchard
Fiscal Policy, Activity,
and the Interest Rate
 Fiscal contraction refers to fiscal policy
that reduces the budget deficit.
 An increase in the deficit is called a fiscal
expansion.
 Consider an increase in taxes.
 Taxes affect the IS curve, not the LM curve.
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Fiscal Policy, Activity,
and the Interest Rate
 Suppose the government raises taxes.
 Higher Taxes affect the IS curve:
– They reduce disposable income, so that there is
less consumption at every level of Y.
Z
ZZ
ZZ
i
Y falls at
every level
of interest.
Y
IS
IS’
Y
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Fiscal Policy, Activity,
and the Interest Rate
 Suppose the government raises taxes.
 Higher Taxes do not affect the LM curve:
– Neither disposable income nor taxes appear in
the money market.
Ms
i
i
LM
i stays the
same at
every level
of Y.
Md
Y
M/P
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Olivier Blanchard
Fiscal Policy, Activity,
and the Interest Rate
The Effects of an
Increase in Taxes
An increase in
taxes shifts the IS
curve to the left,
and leads to a
decrease in the
equilibrium level
of output and the
equilibrium
interest rate.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Fiscal Policy, Activity,
and the Interest Rate
 Higher taxes shift the IS curve to the left and leave
the LM curve unchanged.
 At the old level of interest rates, income has fallen.
 This causes the Md curve to move to the left in the
money market.
 This causes a movement along the LM curve.
– The money market changed due to a change in Y, so the
Md curve shifts but the LM curve does not shift.
 Equilibrium is restored at lower i and lower Y.
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Olivier Blanchard
Monetary Policy, Activity,
and the Interest Rate
 Monetary contraction, or monetary
tightening, refers to a decrease in the
money supply.
 An increase in the money supply is called
monetary expansion.
 Monetary policy does not affect the IS curve,
only the LM curve. For example, an
increase in the money supply shifts the LM
curve down.
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Macroeconomics, 3/e
Olivier Blanchard
Monetary Policy, Activity,
and the Interest Rate
 Suppose the Central Bank expands the
Money Supply.
 Higher Ms does not affect the IS curve:
– The Money Supply does not appear in the
goods market.
Z
ZZ
i
Y stays the
same at
any i.
IS
Y
Y
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Monetary Policy, Activity,
and the Interest Rate
 Suppose the Central Bank expands the Money
Supply.
 Higher Ms shifts the LM curve to the right:
– A greater money supply lowers the interest rate at every
level of income.
i
Ms
Ms’
i
LM
LM
i falls at
every
level of Y.
Md
Y
M/P
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Olivier Blanchard
Monetary Policy, Activity,
and the Interest Rate
The Effects of a
Monetary Expansion
Monetary
expansion leads
to higher output
and a lower
interest rate.
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Olivier Blanchard
Monetary Policy, Activity,
and the Interest Rate
 Higher Money Supply shifts the LM curve to the
right and leave the IS curve unchanged.
 At the old level of income, interest rates have fallen.
 This causes Investment to increase, shifting the ZZ
curve up in the goods market.
 The increase in income causes a movement along
the IS curve.
– The goods market changed due to a change in i, so the
ZZ curve shifts but the IS curve does not shift.
 Equilibrium is restored at lower i and higher Y.
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Macroeconomics, 3/e
Olivier Blanchard
5-4
Using a Policy Mix
 The combination of monetary and fiscal polices is
known as the monetary-fiscal policy mix, or
simply, the policy mix.
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The Clinton-Greenspan Policy
Mix
Table 5-2 Selected Macro Variables for the United States,
1991-1998
1991
1992
1993
1994
1995
1996
1997
1998
Budget surplus (% of
GDP)
(minus sign = deficit)
3.3  4.5  3.8  2.7  2.4  1.4  0.3
0.8
GDP growth (%)
0.9
2.7
2.3
3.4
2.0
2.7
3.9
3.7
Interest rate (%)
7.3
5.5
3.7
3.3
5.0
5.6
5.2
4.8
Over the 90’s, fiscal policy was contractionary and
monetary policy was expansionary. This led to low
interest rates and high output growth.
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The Clinton-Greenspan Policy
Mix
Deficit Reduction and
Monetary Expansion
The appropriate
combination of deficit
reduction and monetary
expansion can achieve a
reduction in the deficit
without adverse effects
on output.
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German Unification and the
German Monetary-Fiscal Tug of
War
The Monetary-Fiscal
Policy Mix of PostUnification Germany
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How does the IS-LM
5-5
Model Fit the Facts?
The Empirical Effects of
an Increase
in the Federal Funds
Rate
In the short run, an
increase in the federal
funds rate leads to
a decrease in output and
an decrease in
production,
But so that, for a while,
sales are below
production and inventories
accumulate.
The two dotted lines and the tinted space between them gives us a
confidence band, a band within which the true value of the effect lies
60%
probability.
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Prentice
Hall Business
Publishing
Macroeconomics, 3/e
Olivier Blanchard
How does the IS-LM
Model Fit the Facts?
The Empirical Effects of
an Increase
in the Federal Funds
Rate
In the short run, an increase in the federal
funds rate leads to
an increase in unemployment,
but little effect on the price level.
The two dotted lines and the tinted space between them gives us a
confidence band, a band within which the true value of the effect lies
60%
probability.
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Prentice
Hall Business
Publishing
Macroeconomics, 3/e
Olivier Blanchard
How does the IS-LM
Model Fit the Facts?
 In general, the IS-LM model seems to be
a pretty good description of the short
run.
– Econometric evidence tells us (within
certain bounds of error) that contractionary
monetary policy
– Lowers employment
– … without changing prices
– (which is what we assumed in this chapter).
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
What did I learn in this chapter?
 Tools and Concepts
– The IS-LM framework.
 The simultaneous determination of income
and interest rates; how different shocks affect
these two.
– The option of choosing alternative policy
mixes to achieve macroeconomic goals.
– The use of “+” and “-” below the argument
of a function to indicate the effect of an
increase in the value of the argument on
the value of the function.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
What did I learn in this chapter?
 Remember
– We still assume prices are fixed,
– But we relax the assumptions that investment is
independent of the interest rate (assumed in
Chapter 3) and that nominal income is fixed
(assumed in Chapter 4).
– Investment is also allowed to depend on output.
– The point of this chapter is to show how goods
and financial markets are related and thus how
output and the interest rate are simultaneously
determined.
– We continue to assume the economy is closed.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard