Download Lecture 2 Open Economy Macroeconomics: IS

Lecture 3
Open Economy Macroeconomics:
IS-LM Model
The IS-LM Model
• The IS/LM model is a macroeconomic tool that
demonstrates the relationship between
interest rates and real output in the goods and
services market and the money market.
• The intersection of the IS and LM curves is the
"General Equilibrium" where there is
simultaneous equilibrium in both markets.
• IS/LM stands for Investment Saving / Liquidity
preference Money supply.
THE IS (Investment = Savings) CURVE
• Inflation and inflationary expectations are
assumed to be stable.
• The IS curve derives a relationship between
interest rates and income in the short run
• An increase in the interest rate reduces
investment by making it more expensive for firms
to borrow money to make investment purchases
and also by increasing the opportunity cost for
those who plan to finance investment projects
using their own funds.
• the relationship between Y and r that ensure
that the goods market is in equilibrium:
spending=production.
• Note that when interest rates are high,
investment falls and therefore Y must fall as
well; the IS curve should show a negative
relationship between r and Y .
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.
• a steep IS curve means that Y does not
respond very much to r.
• In other words, a change in the real interest
rate does not have a significant impact on
GDP.
Movements Along the Curve
• When interest rates decrease, spending rises and
as a result output increases as well. This is
reflected in a movement to a lower point on the
IS curve where interest rates are lower and
output is higher.
• Conversely, when interest rates increase,
spending falls and as a result output decreases as
well. This is reflected in a movement to a higher
point on the IS curve where interest rates are
higher and output is lower.
Parallel Shifts of the IS Curve
• Increases in (1) consumer confidence, (2)
investor confidence, (3) government
purchases, (4) net exports will raise
expenditure, and therefore production of
goods and services, shifting the IS curve out
(rightwards).
• A reduction in lump-sum taxes will increase
expenditure on goods and services and
therefore increase output as well. This will
cause the IS curve to shift out.
Shifts of the IS Curve: T & G
Shifts of the IS Curve
An increase in taxes
shifts the IS curve to
the left.
The Goods Market
and the IS Relation
IS relation: Y  C(Y  T )  I (Y , i )  G
IS Curve captures the effect of nominal interest rate i on output Y,
for given values of T and G. (tax and government purchase).
Investment demand depends negative on interest rate. Hence,
when i increase, the investment and then the total demand will fall.
So will the total output Y.
Therefore, IS curve is downward sloping.
• We derived the IS curve, the first part of the model of
economic fluctuations known as the IS-LM model. The
IS Curve summarized all the combinations of interest
rates and GDP that clear the market for goods and
services in the economy.
• The IS curve by itself cannot give us the value of output
in the economy because it does not have anything to
say about the level of interest rates in the economy.
• Hence we need to derive the LM curve and study its
intersection with the IS curve.
Financial Markets and the LM (Liquidity Preference =
Money Demand) curve
•
LM curve is a relationship that describes the behavior of the money market, which
determines interest rates in the economy.
•
The LM curve consists of the combinations of income and interest rates that clear
the market for money balances (i.e. equate money demand and money supply).
•
The interest rate is determined by the equality of the supply of and the demand for
money:
M  $YL(i )
M = nominal money stock
$YL(i) = demand for money
$Y = nominal income
i = nominal interest rate
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
•
(Why? Because higher i implies a higher Opp. Cost of holding money).
•
LM Curve captures the effect of output Y on nominal interest rate i, for given values
of M (nominal money supply) and P (in short run price is assumed to be fixed).
• When r is high, the demand for money is low because money pays no
interest – the opportunity cost of holding money instead of other
financial assets rises.
• When Y is high the demand for money is high, richer people who buy
more goods are likely to hold more money.
• When prices P are high the demand for money is high since people
need more money to complete their transactions.
• Higher total output implies higher transaction demand. So for given
level of nominal money supply, high demand implies the interest rate
that clear the money market has to increase. So when Y increases, the
nominal interest rate i increases.
• Therefore, LM curve is upward sloping.
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.
Deriving the LM Curve
The Derivation of 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.
MOVEMENTS ALONG THE LM CURVE
• Changes in money demand brought about by changes in Y or
by changes in r are reflected as movements along the LM
curve.
• When income decreases, money demand falls and as a result
interest rates must decrease to restore money market
equilibrium.
• When income increases, money demand rises and as a result
interest rates must increase to restore money market
equilibrium.
• If the CB increases the money supply (expansionary monetary
policy) then from the equation we can see that the vertical (r)
intercept will be lower and the horizontal (Y) intercept will be
larger, i.e. the LM curve shifts out (to the right).
• An increase in the price level has the same effect as a
decrease in the money supply - it shifts the LM curve in (to
the left).
• An increase in exogenous money demand raises the vertical
intercept and makes the horizontal intercept smaller: the LM
curve shifts in (to the left).
• The basic intuition is that the movement of interest rates depends on
the relationship between money demand and money supply.
• Exogenous changes that bring about excess money demand, i.e. drive
money demand above money supply, cause interest rates to rise in
order to lower money demand and equilibrate money demand and
supply. The LM curve will shift in.
• These changes include a fall in money supply, a rise in prices or an
increase in exogenous money demand.
• Exogenous changes that bring about excess money supply, i.e. drive
money supply above money demand cause interest rates to fall in order
to raise money demand and equilibrate money demand and supply.
The LM curve will shift out.
• These changes include an increase in money supply, a fall in prices or a
decrease in exogenous money demand.
• An increase in the supply of money by the CB will result in
an excess supply of money.
• This will cause the LM curve to shift outwards in order to
restore equilibrium.
• An increase in the price level will raise money demand and
result in an excess demand for money.
• This will cause the LM curve to shift inwards to restore
equilibrium
• Another way of intuitively understanding the LM curve is as
follows.
• When there is an excess supply of money, people are more
likely to put the extra money into non monetary financial
assets, so issuers of those assets can offer lower rates of
interest yet still attract buyers.
• Conversely, when there is an excess demand for money,
people are less likely to put money into non monetary
financial assets, so issuers of those assets must offer higher
rates of interest to attract buyers.
Shifts of the LM Curve: M
Shifts of the LM
Curve
An increase in
money leads the
LM curve to shift
down.
IS-LM model
• It is a short run model of the determination of output.
• The model has two main parts: an IS curve that summarizes all the
combinations of Y and r consistent with goods market equilibrium and an
LM curve that summarizes all the combinations of Y and r that are
consistent with money market equilibrium.
• Since the IS curve summarizes all combinations of income and interest
rates that clear the market for goods and services while the LM curve
summarizes all combinations of income and interest rates that clear the
money market, equilibrium income and the equilibrium interest rate are at
the intersection of the two curves.
Putting the IS and the
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.
• Anywhere other than the intersection we would expect there
to be changes in Y or r that restore either goods market or
money market equilibrium.
• Generally, we believe that the money market adjusts very
quickly so the economy will rarely be off the LM curve.
However, it will not stay off the IS curve for very long either as
firms can adjust production to bring it in line with demand.
Fiscal Policy, Activity,
and the Interest Rate
• Fiscal contraction, or fiscal consolidation,
refers to fiscal policy that reduces the budget
deficit.
• An increase in the deficit is called a fiscal
expansion.
• Taxes affect the IS curve, not the LM curve.
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.
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.
Monetary Policy, Activity,
and the Interest Rate
The Effects of a
Monetary Expansion
Monetary expansion
leads to higher output
and a lower interest
rate.
Using a Policy Mix
• The combination of monetary and fiscal polices is known as
the monetary-fiscal policy mix, or simply, the policy mix.
The Effects of Fiscal and Monetary Policy.
Shift of IS
Shift of
LM
Movement of
Output
Movement in
Interest Rate
Increase in taxes
left
none
down
down
Decrease in taxes
right
none
up
up
Increase in spending
right
none
up
up
Decrease in spending
left
none
down
down
Increase in money
none
down
up
down
Decrease in money
none
up
down
up
The Clinton-Greenspan Policy Mix
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
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.
German Unification and the German
Monetary-Fiscal Tug of War
Table 5-2 Selected Macro Variables for West Germany, 19881991
1991
1992
1993
1994
GDP growth (%)
3.7
3.8
4.5
3.1
Investment growth (%)
5.9
8.5
10.5
6.7
2.1
0.2
1.8
2.9
4.3
7.1
8.5
9.2
Budget surplus (% of GDP)
(minus sign = deficit)
Interest rate (%)
German Unification and the German
Monetary-Fiscal Tug of War
The Monetary-Fiscal
Policy Mix of PostUnification Germany
Effects of Monetary and Fiscal
Policy in the IS/LM Model
• Fiscal Policy
– Expansionary fiscal policy shifts the IS curve
to the right
– Contractionary fiscal policy shifts the IS curve
to the left
• Monetary Policy
– Expansionary monetary policy shifts the LM
curve to the right
– Contractionary monetary policy shifts the LM
curve to the left
Fiscal Policy and Crowding Out
• When government expenditures increase,
output and income begin to increase.
• The increase in income increases the
demand for money.
• The increase in money demand increases
the interest rate.
• Higher interest rates cause a decrease in
investment, offsetting some of the
expansionary effect of the increase in
government spending.
1. Let’s assume if government
spending increases by $500, IS
increases by $1000.
Partial Crowding Out
2. The increase in income
increases money demand
which increases interest
rates from 4% to 5%.
LM
3. The increase in the interest
rate causes a decrease in
investment so that the increase
in income is only $600, less that
the full multiplier effect.
$1000
5%
4%
IS1
IS0
$6000
$6600
$7000
Aggregate Output
Full Crowding Out
1. Again government spending
increases by $500, and the IS
increases by $1000.
LM
9%
$1000
2. If the demand for money
is totally insensitive to the
interest rate, the interest rate
increases from 4% to 9%.
3. The increase in the interest
rate causes a decrease in
investment that completely offsets
the increase in government spending.
4%
IS1
IS0
$6000
$7000
Aggregate Output
Ineffective Fiscal Policy
• When complete crowding out occurs, fiscal
policy is ineffective, changing only interest
rates, not output.
• Crowding out is greater if:
– Money demand is very sensitive to income
changes
– Money demand is not very sensitive to
interest rate changes
Monetary Policy in the IS/LM Model
The CB increases the
money supply which
decreases interest rates
and increases investment
and output.
In a liquidity trap, increases
in the money supply do not
decrease interest rates, so
investment and output do
not increase.
LM0
LM0
LM1
LM1
r0
r0
r1
IS
Y0
Y1
Aggregate Output
IS
Y0
Aggregate Output
Ineffective Monetary Policy
• Investment is not sensitive to the interest
rate
– If investment does not respond to interest
rate changes (the IS curve is steep), monetary
policy in ineffective in changing output.
• Liquidity trap
– If increases in the money supply fail to lower
interest rates, monetary policy is ineffective in
increasing output.
Short-Run Outcomes of Policy
Examples of Monetary and Fiscal
Policies
Anticipation of Policy Problems
• The IS/LM model does not take into account the effect of
people’s expectations of policy actions.
• If investors expect the Fed to increase the money supply
and decrease interest rates, they will buy bonds now.
• The increase in demand for bonds increases their price and
decreases interest rates before the money supply is actually
increased.
Monetary Policy Tools and Credit
Condition Problems
• The IS/LM model assumes that interest
rates are the only determinant of
investment.
• Investment also depends on credit
conditions, the willingness of banks to
lend independent of interest rates.
• If banks raise their lending standards,
investment may not respond to
expansionary monetary policy.
Implementation Problems of
Monetary and Fiscal Policy
• Uncertainty about Potential
Output
• Information Lag
• Policy Implementation Lag
Uncertainty About Potential Output
• One macroeconomic policy goal is to keep
output as close to potential as possible.
• In the real world, economists aren’t sure
what potential output is.
• If policymakers use contractionary policy
when the economy is actually below
potential, they create unemployment.
• Using expansionary policy above potential
output will cause inflation.
Information Lag
• The IS/LM model assumes that
policymakers see what is happening in the
economy and can instantly alter policies to
fix any problem.
• In the real world there is an information
lag, a delay between a change in the
economy and knowledge of that change.
Policy Implementation Lag
• The policy implementation lag is the delay between the time
policymakers recognize the need for a policy action and when the
policy is instituted.
• Fiscal policy has a large implementation lag because policy must
be formulated and legislation passed by Congress and the
President.
• Monetary policy has a shorter implementation lag because the
Federal Open Market Committee decides monetary policy.