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  • 1. The IS-LM model The IS curve The LM curve Macroeconomic equilibrium and policy
  • 2. Interest rate i Macroeconomic equilibrium and policy LM The intersection of IS and LM represents the simultaneous equilibrium on the goods and the money market… …For a given value of government spending G, taxes T, money supply M and prices P i* IS Y* Income, Output Y
  • 3. Macroeconomic equilibrium and policy • IS-LM can be used to assess the impact of exogenous shocks on the endogenous variables of the model (interest rates and output) • One can also evaluate the effectiveness of the policy mix, i.e. the combination of: – Fiscal policy: changes to government spending and taxes – Monetary policy: changes to money supply
  • 4. 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
  • 5. Fiscal Policy, the Interest Rate and the IS Curve • Fiscal contraction: a fiscal policy that reduces the budget deficit. – Reducing G or increasing T • Fiscal expansion: increasing the budget deficit. – Increasing G or decreasing T • Taxes (T) and government expenditures (G) affect the IS curve, not the LM curve.
  • 6. Monetary Policy, the Interest Rate, and the LM Curve • Monetary contraction (tightening) refers to a decrease in the money supply. • An increase in the money supply is called monetary expansion. • Monetary policy affects only the LM curve, not the IS curve.
  • 7. Policy Analysis with the IS-LM Model  A Closer Look at Policy • Fiscal Policy and Crowding Out • Monetary Policy and the Liquidity Trap  Real World Monetary and Fiscal Policy
  • 8. 1. The multiplier is 2 and government spending increases by $500, so the IS increases by $1000. Fiscal 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
  • 9. Fiscal Policy and Crowding Out • When government expenditures increase or taxes are reduced, 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.
  • 10. 1. The multiplier is 2 and government spending increases by $500, so the IS increases by $1000. LM 9% $1000 Full Crowding Out 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
  • 11. 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
  • 12. Monetary Policy and Liquidity Traps The RBI 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
  • 13. 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.
  • 14. Interaction between monetary and fiscal policy • IS-LM Model: Monetary and fiscal policy variables (M, G, and T) are exogenous. • Real world: Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa. • Such responses by the central bank may affect the effectiveness of fiscal policy
  • 15. The RBI’s response to G >0 • Suppose the government increases G. • Possible RBI responses: 1. hold M constant 2. hold r constant 3. hold Y constant • In each case, the effects of G on Y are different…
  • 16. Response 1: Hold M constant When G increases, the IS curve shifts right. If RBI holds M constant, then LM curve does not shift. As a result, interest rates rise. This has a crowdingout effect. Consequently, GDP increases, but not a lot. r LM r2 r1 IS2 IS1 Y1 Y2 Y
  • 17. Response 2: Hold r constant If Govt. raises G, the IS curve shifts right. To keep r constant, Fed increases M to shift LM curve right. r LM1 LM2 r2 r1 IS2 Results: IS1 Y Y3 r 0 Y1 Y1 Y2 Y3 Y
  • 18. Response 3: Hold Y constant If Govt. raises G, the IS curve shifts right. To keep Y constant, RBI reduces M to shift LM curve left. LM2 LM1 r r3 r2 r1 IS2 IS1 Y 0 r r3 Y1 Y2 r1 Y
  • 19. Shocks in the IS-LM model 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
  • 20. Shocks in the IS-LM model 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 reduce money demand.
  • 21. Analyze shocks with the IS-LM Model Use the IS-LM model to analyze the effects of 1. a boom in the stock market that makes consumers wealthier. 2. after a wave of credit card fraud, consumers using cash more frequently in transactions. For each shock, a. use the IS-LM diagram to show the effects of the shock on Y and r. b. determine what happens to C, I, and the unemployment rate.
  • 22. Macroeconomic equilibrium and policy   The two policies are not independent, as they both affect the endogenous variables:  The interest rate i  Income Y  Hence the idea of a policy mix… 3 examples of policy mix issues  The good: the Clinton deficit reduction in 1993,  The bad: the German reunification in 1992,  The ugly : the debate on the “liquidity trap”.
  • 23. Macroeconomic equilibrium and policy Interest rate i The Clinton deficit reduction in 1993 1. Clinton decides to reduce the US deficit (by increasing taxes) , which shifts IS to the left LM 2. At the same time, Alan Greenspan increases money supply in order to stimulate output LM’ i1 3. The end result is that output is held constant, with a strong fall in interest rates i2 IS i3 IS’ Y2 Y1 Income, Output Y
  • 24. Macroeconomic equilibrium and policy Interest rate i The German reunification in 1992 1. The German reunification resulted in a large shift of IS to the right, mainly because of the extra government spending and increase in consumption from the ex DDR LM’ LM i3 i2 IS’ i1 IS Y1 Y2 2. At the same time, the Bundesbank drastically reduced money supply due to inflation fears, as the ostmark/DM exchange rate had been set at 1 for 1 due to political reasons 3. The end result of this lack of coordination is that output was slightly reduced, with a large increase in interest rates. Income, Output Y
  • 25. Macroeconomic equilibrium and policy Interest rate i The current liquidity trap ? 1. The subprime-based financial crisis has frozen credit markets as well as depressed consumption. This has caused a large fall in investment, shifting IS to the left LM LM’ 2. The central bank have responded by injecting large amounts of liquidity in the markets, and making credit easily available(“Quantitative easing”). This pushes LM to the right. 3. But these policies have had no effect, and the rate of interest is practically zero (ZIRP!) i1 i2 IS’ Y2 Y1 IS 3. The only way out is a large fiscal policy push. Income, Output Y