Transcript IS-LM and AD-AS model

0VS452 + 5EN253
Lecture 8 (part II) + Lecture 9
IS-LM MODEL AND
AD-AS MODEL
Eva Hromádková, 12.4 2010 + 19.4 2010
Overview of Lecture 8 – part II
2
IS-LM model of AD curve:
 Model for AD curve => analysis of stabilization
policies
 IS curve – goods market


LM curve – money market


Fiscal policy – expenditures and taxes
Monetary policy – money supply
Equilibrium – interest rates
(slides by Ron Cronowich)
IS-LM model
Context
3
We have already introduced the model of aggregate
demand (QTM) and aggregate supply.
Long run
 prices flexible
 output determined by factors of production &
technology
 unemployment equals its natural rate
 Short run
 prices fixed
 output determined by aggregate demand
 unemployment is negatively related to output
IS-LM model
Context II
4
Today we will develop IS-LM model, the theory that
explains the aggregate demand curve
First, we focus on the short run and assume hat price level
is fixed
Then, we allow price to be flexible, and derive AD curve
Finally, we analyze the effect of fiscal and monetary
policy on the most important macroeconomic aggregates
– output and unemployment
IS curve
Keynesian cross
5

A simple closed economy model in which income is
determined by expenditure.
(due to J.M. Keynes)

Notation:
I = planned investment
E = C + I + G = planned expenditure
Y = real GDP = actual expenditure

Difference between actual & planned expenditure:
unplanned inventory investment
IS curve
Elements of the Keynesian cross
6
Consumption function:
C = Ca + MPC*(Y-T)
Govt. policy variables:
G, T
Investment:
I = I(r)
Planned expenditure:
E = C(Y-T) + I(r) + G
(aggregate demand)
Equilibrium:
Y=E
IS curve
Graphing planned expenditure
7
E
planned
expenditure
E =C +I +G
Slope
is MPC
income, output, Y
IS curve
Graphing the equilibrium condition
8
E
E =Y
planned
expenditure
45º
income, output, Y
IS curve
Equilibrium value of income
9
E
planned
expenditure
E =Y
E<Y
E>Y
income, output, Y
E>Y: depleting inventories => produce more
E<Y: accumulating inventories=> produce less
IS curve
Fiscal policy
10

Fiscal stimulus:
 Increase
in government expenditures
 Cut taxes
 Increase transfer payments

Fiscal restraint:
 Decrease
in government expenditures
 Increased taxes
 Decreased transfer payments
IS curve
Increase in government purchases
11
E
E =C +I +G2
E =C +I +G1
G
Looks like
Y>G
Y
E1 = Y1
Y
E2 = Y2
IS curve
Why is change in Y > change in G?
12




Def: Government purchases multiplier:
Y
G
Initially, the increase in G causes an equal increase in Y:
Y = G.
But Y  C (Y-T)
 further Y
 further C
 further Y
So the government purchases multiplier will be greater
than one.
IS curve
Change in G - Sum up changes in expenditure
13
Y  G  MPC  G   MPC MPC  G 
 MPC MPC MPC  G    ...

 
 

 G  MPC 1G  MPC 2 G  MPC 3 G ...
This is a standard geometric series from algebra:
1

G
1  MPC
So the multiplier is:
Y
1

 1 for 0 < MPC < 1
G 1  MPC
IS curve
Increase in taxes
14
E
E =C1 +I +G
E =C2 +I +G
At Y1, there is now
an unplanned
inventory buildup…
C = MPC T
…so firms
reduce output,
and income falls
toward a new
equilibrium
Y
E2 = Y2
Y
E1 = Y1
IS curve
Change in T - Sum up changes in expenditure
15
equilibrium condition
in changes
Y  C  I  G
 C
I and G exogenous
 MPC   Y  T
Solving for Y :
Final result:

(1  MPC) Y   MPC  T
  MPC 
Y  
  T
 1  MPC 
IS curve
Tax multiplier
16
Question: how is this different from the government spending
multiplier considered previously?
The tax multiplier:
…is negative:
An increase in taxes reduces consumer spending, which reduces
equilibrium income.
…is smaller than the govt spending multiplier:
(in absolute value) Consumers save the fraction (1-MPC) of a tax
cut, so the initial boost in spending from a tax cut is smaller than
from an equal increase in G.
IS curve
How to derive the IS curve I
17
def: a graph of all combinations of r and Y that result in goods
market equilibrium,
i.e. actual expenditure (output) = planned expenditure
The equation for the IS curve is:
Y = C(Y-T) + I(r) + G
The IS curve is negatively sloped.
Intuition:
A fall in the interest rate motivates firms to increase investment
spending, which drives up total planned spending (E ).
To restore equilibrium in the goods market, output (a.k.a. actual
expenditure, Y ) must increase.
IS curve
How to derive the IS curve II
E =Y
E
r
E =C +I (r1 )+G
 I
 E
 Y
E =C +I (r2 )+G
I
r
Y1
Y2
Y1
Y2
Y
r1
r2
IS
Y
IS curve
Fiscal policy and IS curve – example of increase in G
At given value of r,
E =Y
E
E =C +I (r1 )+G2
E =C +I (r1 )+G1
G  E  Y
…so the IS curve
shifts to the right.
The horizontal
distance of the
IS shift equals
1
Y 
G
1  MPC
r
Y1
Y
Y2
r1
Y
Y1
Y2
IS1
IS2
Y
LM curve
How to build the LM curve
20
The theory of liquidity preference:


Developed by John Maynard Keynes.
A simple theory in which the interest rate
is determined by money supply and
money demand.
LM curve
Money supply
The supply of real
money balances is
fixed.
r
interest
rate
M P 
M P
s
M/P
real money
balances
LM curve
Money demand
22
r
The demand for
real money
balances is
negatively
dependent on
interest rate.
interest
rate
M
P
s
L (r,Y )
M P
M/P
real money
balances
LM curve
Equilibrium
23
r
The interest rate
adjusts
to equate the
supply and
demand for
money
interest
rate
M
P
r1
s
L (r,Y )
M P
M/P
real money
balances
LM curve
Monetary policy – How can CB affect the interest rate?
24
r
To reduce r, central bank
reduces M.
In reality, this is hardly he
case.
More used technique =
change of discount rate.
interest
rate
r2
r1
L (r ,Y)
M2
P
M1
P
M/P
real money
balances
LM curve
How to derive LM curve?
25
The LM curve is a graph of all combinations of r and Y
that equate the supply and demand for real money
balances.
The equation for the LM curve is:
M P  L (r ,Y )
The LM curve is positively sloped.
Intuition: An increase in income raises money demand.
Since the supply of real balances is fixed, there is now excess
demand in the money market at the initial interest rate. The
interest rate must rise to restore equilibrium in the money market.
LM curve
How to derive LM curve II
(b) The LM curve
(a) The market for
r
real money balances
r
LM2
LM1
r2
r2
r1
L (r , Y1 )
M2
P
M1
P
M/P
r1
Y1
Y
IS-LM model
Equilibrium
r
The short-run equilibrium is the
combination of r and Y that
simultaneously satisfies the
equilibrium conditions in the
goods & money markets:
LM
IS
Y  C (Y  T )  I (r )  G
M P  L (r ,Y )
Equilibrium
interest
rate
Y
Equilibrium
level of
income
IS-LM model
Fiscal policy: An increase in government purchases
r
LM
1. IS curve shifts right
by
1
G
1  MPC
causing output &
income to rise.
r2
r1
2.
2. This raises money
demand, causing the
interest rate to rise…
3. …which reduces investment, so the
final increase in Y
1
is smaller than
G
1  MPC
IS2
1.
IS1
Y1
Y
Y2
3.
slide 28
IS-LM model
Fiscal policy: A tax cut
r
LM
Because consumers save
(1MPC) of the tax cut,
the initial boost in
r2
spending is smaller for T 2.
r1
than for an equal G…
and the IS curve
shifts by
MPC
1.
T
1  MPC
1.
IS1
Y1 Y2
2.
2. …so the effects on r and Y
are smaller for a T than
for an equal G.
IS2
slide 29
Y
IS-LM model
Monetary Policy: an increase in M
1. M > 0 shifts
the LM curve down
(or to the right)
2. …causing the
interest rate to fall
3. …which increases
investment, causing
output & income to
rise.
LM1
r
LM2
r1
r2
IS
Y1
Y
Y2
slide 30
IS-LM model
Shocks I
31
LM shocks: exogenous changes in the demand for
money.
Examples:
• a wave of credit card fraud increases demand for
money
• more ATMs or the Internet banking reduce money
demand
IS-LM model
Shocks II
32
IS shocks: exogenous changes in the demand for goods
& services.
Examples:
• stock market boom or crash
 change in households’ wealth
 C
• change in business or consumer
confidence or expectations
 I and/or C
IS-LM model
When is fiscal policy more effective?
Fiscal policy is effective (Y will rise much) when:
LM flatter
r
IS1
IS2
1
LM
2
2’
LM’
As the rise in G raises Y,
the increase in money demand
does not raise r much:
so investment is not crowded
out as much.
Y1 Y2 Y2’
slide 33
IS-LM Model
When is monetary policy more effective?
Monetary policy is effective (Y will rise much) when:
IS flatter
r
IS
LM1
1
LM2
2’
2
Y1 Y2 Y2’
IS’
As a rise in M lowers the
interest rate (r),
investment rises more in
response to the fall in r,
so output rises more.
slide 34
Aggregate demand
How to get from IS-LM to AD
35



So far, we’ve been using the IS-LM model to
analyze the short run, when the price level is
assumed fixed.
However, a change in P would shift the LM
curve and therefore affect Y.
The aggregate demand curve
(introduced in chap. 9 ) captures this
relationship between P and Y
Aggregate demand
How to get from IS-LM to AD II
Intuition for slope
of AD curve:
P  (M/P )
r
LM(P2)
LM(P1)
r2
r1
 LM shifts left
 r
 I
 Y
IS
P
Y2
Y1
Y
P2
P1
AD
Y2
Y1
Y
Aggregate demand
Effect of monetary policy
The Fed can increase
aggregate demand:
M  LM shifts right
 r
 I
 Y at each
value of P
r
LM(M1/P1)
LM(M2/P1)
r1
r2
IS
P
Y1
Y2
Y
P1
Y1
Y2
AD2
AD1
Y
Aggregate demand
Effect of fiscal policy
r
Expansionary fiscal policy
(G and/or T )
increases agg. demand:
LM
r2
r1
IS2
IS1
T  C
 IS shifts right
P
 Y at each
value of P
P1
Y1
Y1
Y2
Y2
Y
AD2
AD1
Y
IS-LM and AD-AS model
combination of short & long run
In the short-run
equilibrium, if
then over time,
the price level will
Y Y
rise
Y Y
fall
Y Y
remain constant
slide 39
IS-LM and AD-AS model
short & long run effect of IS shock I
r
LRAS LM(P )
1
A negative IS shock
shifts IS and AD left,
causing Y to fall.
IS2
P
Y
LRAS
P1
IS1
Y
SRAS1
Y
AD1
AD2
Y
IS-LM and AD-AS model
short & long run effect of IS shock II
In the new short-run
equilibrium, Y  Y
r
LRAS LM(P )
1
IS2
Y
P
IS1
Y
LRAS
P1
SRAS1
Y
AD1
AD2
Y
IS-LM and AD-AS model
short & long run effect of IS shock II
In the new short-run
equilibrium, Y  Y
Over time,
P gradually falls,
which causes
• SRAS to move down
• M/P to increase,
which causes LM
to move down
r
LRAS LM(P )
1
IS2
Y
P
IS1
Y
LRAS
P1
SRAS1
Y
AD1
AD2
Y
IS-LM and AD-AS model
short & long run effect of IS shock III
r
LRAS LM(P )
1
LM(P2)
Over time,
P gradually falls,
which causes
• SRAS to move down
• M/P to increase,
which causes LM
to move down
IS2
Y
P
IS1
Y
LRAS
P1
SRAS1
P2
SRAS2
Y
AD1
AD2
Y
IS-LM and AD-AS model
short & long run effect of IS shock IV
r
LRAS LM(P )
1
This process continues
until economy reaches
a long-run equilibrium
with
Y Y
LM(P2)
IS2
Y
P
IS1
Y
LRAS
P1
SRAS1
P2
SRAS2
Y
AD1
AD2
Y
The Great Depression
CASE STUDY
220
billions of 1958 dollars
30
Unemployment
(right scale)
25
200
20
180
15
160
10
Real GNP
(left scale)
140
120
1929
5
0
1931
1933
1935
1937
1939
percent of labor force
240
slide 46
The Great Depression
CASE STUDY

Real side of economy:
 Output:
 Consumption:
 Investment:
 Gov.
purchases:
falling
falling
falling much
fall (with a delay)
slide 47
slide 48
The Great Depression
CASE STUDY

Nominal side:
 Nominal
interest rate: falling
 Money supply (nominal):
falling
 Price level:
falling (deflation)
slide 49
The Great Depression
CASE STUDY
The Spending Hypothesis:
Shocks to the IS Curve


asserts that the Depression was largely due to an
exogenous fall in the demand for goods & services -a leftward shift of the IS curve
evidence:
output and interest rates both fell, which is what a
leftward IS shift would cause
slide 50
The Spending Hypothesis:
Reasons for the IS shift
1. Stock market crash  exogenous C
 Oct-Dec 1929: S&P 500 fell 17%
 Oct 1929-Dec 1933: S&P 500 fell 71%
2. Drop in investment
 “correction” after overbuilding in the 1920s
 widespread bank failures made it harder to obtain
financing for investment
3. Contractionary fiscal policy
 in the face of falling tax revenues and increasing
deficits, politicians raised tax rates and cut spending
slide 51
The Money Hypothesis:
A Shock to the LM Curve


asserts that the Depression was largely due to
huge fall in the money supply
evidence:
M1 fell 25% during 1929-33.
But, two problems with this hypothesis:
1.
2.
P fell even more, so M/P actually rose slightly
during 1929-31.
nominal interest rates fell, which is the opposite
of what would result from a leftward LM shift.
slide 52
The Money Hypothesis:
Revision


There was a big deflation: P fell 25% 1929-33.
A sudden fall in expected inflation means the ex-ante real
interest rate rises for any given nominal rate (i)
ex ante real interest rate = i – e


This could have discouraged the investment expenditure and
helped cause the depression.
Since the deflation likely was caused by fall in M, monetary
policy may have played a role here.
slide 53