Download Intermediate Macroeconomics – Lecture Note #4

Intermediate Macroeconomics – Lecture Note #4
Dr. Todd R. Yarbrough
IV. The IS-LM Framework
Our Stylized Facts so far:
Output (Y) is determined in equilibrium in the goods market, the so-called Keynesian Cross, and the money
market.
The goods market essentially determines how much stuff gets made and purchased by consumers (C), businesses
(I), and the government spending (G).
The money market determines the nominal interest rate (i) in our economic system at the equilibrium of the Real
MS
) and Money Demand (M d = Y × L(i)).
Money Supply (
P
1. The IS Curve (Keynesian Cross Set-up)
Let’s bring back the goods market equilibrium from Lecture 1:
Y
Z, Y
Z 00
Y
00
=Z
00
Z0
Z
Y 0 = Z0
Y =Z
c0 − c1 T + I¯00 + G
c0 − c1 T + I¯0 + G
c0 − c1 T + I¯ + G
0
Y
Y0
Y 00
Y
Let’s assume that what is going on above is just that interest rates have been falling. As a result more investment
is occurring in the goods market. More stuff is being bought and sold. This moves us along the Y curve to a
higher level of output. First we move from Y to Y’ because we went from I to I’. We then go from Y’ to Y”,
because we go from I’ to I”. Again, both of these moves occur because interest rates are falling, for whatever
reason.
[PANEL A] This tells us that in the goods market, Output (Y) and the nominal interest rate (i) are negatively
correlated. We derive the IS Curve from this behavior (on the next page).
[PANEL B] In this graph you should see the upward shift in Demand (Z) that occurs because of successive
increases in Investment (I) which themselves occurred because of successive decreases in Nominal Interest Rate
(i).
[PANEL C] The IS Curve will shift when there is a change in Autonomous Spending ((C-T) + I + G) that arises
from anything but interest rate changes. If for example the government increases spending, the IS curve will shift
to the right. On the other hand, if the government were to raise taxes, then the IS Curve would shift to the left.
1
Y
Z, Y
(A)
Z 00
Z0
Z
0
Y0
Y
Y 00
Y
i
(B)
i
i0
i00
IS
0
Y0
Y 00
Y
Y
i
(C)
i
IS− IS IS+
0
Y− Y Y+
2
Y
2. The LM Curve
There is something confounding about the analysis derived in the previous section. Most notably, that output is
negatively correlated with interest rates. In one way it makes perfect sense, as interest rates fall, the incentive
to borrow rises among consumers, producers, and the government. For example, it is often argued that the
government should take advantage of low interest rates and take care of infrastructure projects during such a
time period. Such an argument is pretty solid, when you consider the work will most likely be required due to
depreciation... but I digress.
One thing however should confound you... As interest rates are falling, the incentive to hold cash rises. Meaning,
we expect folks to save less during periods of low interest rates, as reserves don’t pay much and they themselves
are trying to take advantage of the low rates and spend money, not save it.
[PANEL D] Such behavior should result in the Money Demand (M d ) curve shifting upward, putting UPWARD
pressure on interest rates, all else equal.
[PANEL E] In other words, when it comes to the Money Market, we expect interest rates and output to be
positively correlated.
Let’s recall our Money Market graph from Lecture 3:
i
Ms
i
(E)
LM
iup
iup
(D)
i∗
i∗
M D+
idown
idown
MD
M D−
0
M
Y−
0
M
Y
Y+
Y
This is a pretty straightforward story. Money Demand = Y × L(i). So, as output (Y) rises putting downward
pressure on interest rates in the good market, Money Demand also rises putting upward pressure on interest
rates. You can think about this just like prices in a normal goods market. As prices rise, suppliers want to supply
more and consumers want to buy less, and as prices fall, suppliers want to supply less and consumers want to
buy more. This friction creates our equilibrium condition at a market price. In a similar way, the goods market
(IS Curve) is putting downward pressure on interest rates as the economy grows, while the money market (LM
Curve) is putting upward pressure on interest rates as the economy grows.
The only thing that shifts the LM Curve, for now, is central bank policy changes. Increases in the Money Supply
and targeting lower interest rates (expansionary money policy) shift the LM Curve to the right, while decreases
in the Money Supply and targeting higher interest rates (contractionary monetary policy).
i
LM −
LM
LM +
i
0
Y−Y Y+
3
Y
3. Equilibrium in IS-LM
We economists love our equilibriums, don’t we? Well, the IS-LM equilibrium is a bit special.
i
LM
i∗
IS
0
Y
Y
The equilibrium nominal interest rate (i∗ ) clears both the goods market and the money market in equilibrium.
If the interest rate is above equilibrium, we have surplus demand for money relative to consumption [too little
borrowing]. If the interest rate is below equilibrium, we have a shortage of demand for money relative to consumption [too much borrowing]. So, equilibrium here sets a nominal interest rate at an equilibrium level of potential
output, with all demand for borrowing equaling the supply of borrowing, and all demand for goods equaling the
supply of goods.
This means that shifts in either the IS or LM curve, all else equal, will lead to changes in the market clearing
interest rate in both the goods and money markets.
[PANEL F] Shift to the right of the IS curve causes an increase in the nominal interest rate, all else equal. Shift
to the left of the IS curve causes a reduction of the nominal interest rate, all else equal.
[PANEL G] Shift to the right of the LM curve causes a reduction in the nominal interest rate, all else equal. Shift
to the left of the LM curve causes an increase in the nominal interest rate, all else equal.
i
i
(F)
LM −
LM
LM
LM +
i+
i
i−
i+
i
i−
IS−
0
Y− Y
Y+
(G)
IS IS+
IS
0
Y
4
Y− Y
Y+
Y