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Goods & Financial Markets: The IS-LM Model The IS-LM Model The determination of output and interest rates in the short-run Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets Slide #1 Goods & Financial Markets: The IS-LM Model The goods market and the IS relation Equilibrium in the goods market: Production (Y) = Demand (Z) Or Investment = Saving “IS” Relation Demand (Z)= C+I+G C=C(Y-T) T & G are given Now let Investment depend on the level of sales (Y) and the interest rate (i): Blanchard: Macroeconomics I I (Y , i ) ( ,) Chapter 5: Goods & Financial Markets Slide #2 Goods & Financial Markets: The IS-LM Model The IS curve Equilibrium: Y C (Y T ) I G I I (Y , i ) Y C (Y T ) I (Y , i ) G Supply of Goods Demand for Goods (Z) In the goods market, the higher the interest rate, the lower is investment and the lower is equilibrium output. Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets Slide #3 Goods & Financial Markets: The IS-LM Model Interest Rate, i The IS curve Shifts in the IS Curve: An increase in taxes shifts the IS curve to the left i IS (T) IS´ (T´ > T) Y´ Y Output, Y Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets Slide #4 Goods & Financial Markets: The IS-LM Model Interest Rate, i The IS curve Shifts in the IS Curve: An increase in G shifts the IS curve to the right i IS´ (G´ > G) IS (G) Y Y´ Output, Y Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets Slide #5 Goods & Financial Markets: The IS Curve Shifts in the IS curve What do you think: How would a decrease in consumer confidence shift the IS curve? Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets Slide #6 Financial Markets and the LM Relation Money market equilibrium: Demand for liquidity (L) = Supply of Money (M) M= nominal money supply (controlled by the Central Bank) $YL(i) = Demand for money (function of nominal income and the interest rate) Equilibrium Interest Rate: M=$YL(i) Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets Slide #7 Financial Markets and the LM Relation Real money, real income, and the interest rate $Y Real Income (Y ) P Real Money Supply LM relation: Blanchard: Macroeconomics M P =Real Money Demand: Y(L)i M Y ( L)i P Chapter 5: Goods & Financial Markets Slide #8 Financial Markets and the LM Relation An increase in demand for real balances: Interest Rate, i Ms Increase in Y => increases Md which increases i i´ i A´ A Md´ (for Y´ > Y) Md (for Y) M/P (Real) Money, M/P Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets Slide #9 Financial Markets and the LM Relation The LM curve Interest Rate, i Interest Rate, i Ms A´ i´ A i i´ i LM (M/P) A´ A Md´ (for Y´ > Y) Md (for Y) M/P (Real) Money, M/P Blanchard: Macroeconomics Y Y´ Income, Y Chapter 5: Goods & Financial Markets Slide #10 Financial Markets and the LM Relation Shifts in the LM Curve: Showing changes in M & P The LM curve Interest Rate, i Ms i LM (M/P) LM´ (M´/P > M/P) i´ b i´ i´2 Interest Rate, i Ms´ b i´2 b´ a i a´ i2 Md´ (for Y´ > Y) b´ a i2 a´ Md M/P (for Y) M´/P (Real) Money, M/P Blanchard: Macroeconomics Y Y´ Income, Y Chapter 5: Goods & Financial Markets Slide #11 The IS-LM Model Exercises Equilibrium Requires: IS : Y C (Y T ) I (Y , i ) G M LM : YL (i ) P or IS LM Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets Slide #12 The IS-LM Model Exercises The IS-LM Equilibrium Graphically Interest Rate, i LM i & Y is the only interest rate, output combination that yields a simultaneous equilibrium in the goods and financial markets i IS Y Output, Y Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets Slide #13 Fiscal Policy, Activity, and the Interest Rate A Scenario: Question: The President and Congress agree on a policy to reduce the budget deficit by increasing taxes, while holding gov’t spending constant. What impact will this fiscal contraction policy have on output and interest rates? What shifts? IS, LM or both? ANSWER: IS Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets Slide #14 Fiscal Policy, Activity, and the Interest Rate The IS-LM Equilibrium Graphically Interest Rate, i LM • IS & LM: Before the tax increase Equilibrium A: i & Y • IS´: After the tax increase • Would the tax increase change LM? A F i A´ i´ • Disequilibrium at i (F, A) after tax increase • i´, Y´ New equilibrium A´ • The fiscal contraction lowered interest and output IS (T) IS´ (T´ > T) Y´ Y Output, Y Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets Slide #15 Fiscal Policy, Activity, and the Interest Rate Here’s one for the devil’s advocate… Is deficit reduction good or bad for investment? Interest rate falls good for investment But Output falls bad for investment Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets Slide #16 Monetary Policy, Activity, and the Interest Rate Monetary Policy, Activity, and the Interest Rate A Scenario: Question: The Fed engages in monetary expansion, i.e., it increases the money supply through open market operations What impact will the monetary expansion have on output and interest? What shifts? IS, LM, or both? ANSWER: LM Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets Slide #17 Monetary Policy, Activity, and the Interest Rate The IS-LM Equilibrium Graphically LM (M/P) Interest Rate, i LM´ (M´/P > M/P) • IS & LM: Before increasing M Equilibrium A: i & Y i • LM´: After increasing M B A • Disequilibrium at i (A, B) A´ • New equilibrium A´: i´ & Y´ i´ • Monetary expansion lowered i & increased Y IS Y Y´ Output, Y Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets Slide #18 Fiscal Policy and Monetary Policy: Activity and the Interest Rate The effects of fiscal and monetary policy Shift in IS Shift in LM Movement in 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 Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets Slide #19 Using a Policy Mix The Clinton-Greenspan Policy Mix The policy dilemma of 1992: Recall: Record high federal budget deficit (4.5% of GNP) High unemployment and slow growth Deficit reduction reduces output Expansionary fiscal policy increases the deficit Solution: Policy Mix Blanchard: Macroeconomics Deficit reduction and expansionary monetary policy Chapter 5: Goods & Financial Markets Slide #20 Using a Policy Mix The Clinton-Greenspan Policy Mix LM Interest Rate, i LM´ • IS & LM: Before policy changes Equilibrium A: i & Y • IS´: After deficit reduced A i • B equilibrium without monetary expansion B • LM´ after monetary expansion i´ A´ IS • New equilibrium i´, Y´ IS´ Y Y´ Output, Y Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets Slide #21 Using a Policy Mix The Clinton-Greenspan Policy Mix Observations: • Strong consumer confidence and stock market shifting IS from 1992 to 1998 • The strong expansion automatically reduced the deficit (1% growth reduces the deficit to GNP ratio by 0.5%) Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets Slide #22 Using a Policy Mix The Clinton-Greenspan Policy Mix The U.S. Economy 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 Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets Slide #23 Adding Dynamics Observations: •Changes in output adjust slowly to changes in the goods market (IS) •Interest rates adjust instantaneously to changes in the financial markets (LM) Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets Slide #24 Adding Dynamics Dynamics Graphically Adjusting to a monetary contraction B A´ iA Output decreases slowly IS B iB iA A IS´ Yb Ya Output, Y Blanchard: Macroeconomics LM´ LM Interest Rate, i Interest Rate, i Adjusting to a tax increase Interest rates adjust instantaneously Ya Output, Y Chapter 5: Goods & Financial Markets Slide #25 Adding Dynamics The Dynamics of Monetary Contraction with IS-LM LM´ Interest Rate, i LM • A: Initial equilibrium (i & Y) A´´ i´´ • LM´: After reducing money supply A´ i´ • i rises to i´´ • Higher i reduces demand and output slowly A´´ to A´ A i • Equilibrium restored at A´: i´, Y´ IS Y´ Y Output, Y Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets Slide #26 Adding Dynamics A Summary •Monetary policy changes interest rates rapidly and output slowly •The Central Bank must consider the output lag when implementing monetary policy Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets Slide #27 Does the IS-LM Model Actually Capture What Happens in the Economy? The Empirical Effects of an Increase in the Federal Funds Rate Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets Slide #28 Does the IS-LM Model Actually Capture What Happens in the Economy? The Empirical Effects of an Increase in the Federal Funds Rate Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets Slide #29 Does the IS-LM Model Actually Capture What Happens in the Economy? The Empirical Effects of an Increase in the Federal Funds Rate Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets Slide #30 Does the IS-LM Model Actually Capture What Happens in the Economy? The Empirical Effects of an Increase in the Federal Funds Rate Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets Slide #31 Does the IS-LM Model Actually Capture What Happens in the Economy? The Empirical Effects of an Increase in the Federal Funds Rate Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets Slide #32 Does the IS-LM Model Actually Capture What Happens in the Economy? Summary The IS-LM model is consistent with economic observations The IS-LM model explains movements in economic activity over the short-run Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets Slide #33