Ecnomics

Prepared by:Prepared by:
Fernando Quijano and YvonnFernando Quijano and Yvonn
QuijanoQuijano
And Modified by Gabriel MartinezAnd Modified by Gabriel Martinez
55
C H A P T E RC H A P T E R
Goods andGoods and
Financial Markets:Financial Markets:
The IS-LM ModelThe IS-LM Model

© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business Publishing Macroeconomics, 3/eMacroeconomics, 3/e Olivier BlanchardOlivier Blanchard
How are Output and the InterestHow are Output and the Interest
Rate Jointly Determined in the ShortRate Jointly Determined in the Short
Run?Run?
 Output and the interest rate are determined byOutput and the interest rate are determined by
simultaneous equilibrium in the goods and moneysimultaneous equilibrium in the goods and money
markets.markets.
– In the short run, we assume that production responds toIn the short run, we assume that production responds to
demand without changes in price (i.e., price is fixed), sodemand without changes in price (i.e., price is fixed), so
output is determined by demand.output is determined by demand.
 The determination of output is the fundamentalThe determination of output is the fundamental
issue in macroeconomics.issue in macroeconomics.
– The interest rate affects output (through investment) andThe interest rate affects output (through investment) and
output affects the interest rate (through moneyoutput affects the interest rate (through money
demand), so it is necessary to consider thedemand), so it is necessary to consider the
simultaneous determination of output and the interestsimultaneous determination of output and the interest
rate.rate.

The Goods MarketThe Goods Market
and theand the ISIS RelationRelation
 Equilibrium in the goods market existsEquilibrium in the goods market exists
when production,when production, YY, is equal to the, is equal to the
demand for goods,demand for goods, ZZ..
 In the simple model developed inIn the simple model developed in
chapter 3, the interest rate did not affectchapter 3, the interest rate did not affect
the demand for goods. The equilibriumthe demand for goods. The equilibrium
condition was given by:condition was given by:
5-1
Y C Y T I G= − + +( )

Investment, Sales,Investment, Sales,
and the Interest Rateand the Interest Rate
 In this chapter, we capture the effectsIn this chapter, we capture the effects
of two factors affecting investment:of two factors affecting investment:
– The level of sales (+)The level of sales (+)
– The interest rate (-)The interest rate (-)
),(
−+
= iYII

The Determination of OutputThe Determination of Output
I I Y i= ( , )
Y C Y T I Y i G= − + +( ) ( , )
 Taking into account the investment relationTaking into account the investment relation
above, the equilibrium condition in theabove, the equilibrium condition in the
goods market becomes:goods market becomes:
– Notice we don’t assume that the relationNotice we don’t assume that the relation
between C and Y, or between I and Y,between C and Y, or between I and Y, hashas to beto be
linear.linear.

The Determination of OutputThe Determination of Output
Note: The ZZ line is flatter than the 45° line because the econometric
evidence tells us that increases in consumption and investment do not
exceed the corresponding increase in output.
The demand for goods is
an increasing function of
output. Equilibrium
requires that the demand
for goods be equal to
output.
Equilibrium in the GoodsEquilibrium in the Goods
MarketMarket

Consumption on GDP
y = 0.6942x - 106.02
R2
= 0.9965
0.0
2000.0
4000.0
6000.0
8000.0
10000.0
0.0 2000.0 4000.0 6000.0 8000.0 10000.0 12000.0
69.0=
∆
∆
Y
C

Investment on GDP
y = 0.1619x - 128.41
R
2
= 0.9748
-500.0
0.0
500.0
1000.0
1500.0
2000.0
0.0 2000.0 4000.0 6000.0 8000.0 10000.0 12000.0
16.0=
∆
∆
Y
I

Change of Consumption on Change of GDP
y = 0.2857x + 0.0234
R2
= 0.2296
-0.1
-0.05
0
0.05
0.1
0.15
-0.15 -0.1 -0.05 0 0.05 0.1 0.15 0.2 0.25

Change of Investment on Change of GDP
y = 0.4868x + 0.0332
R2
= 0.0217
-0.6
-0.4
-0.2
0
0.2
0.4
0.6
0.8
1
-0.15 -0.1 -0.05 0 0.05 0.1 0.15 0.2 0.25

Deriving theDeriving the ISIS CurveCurve
An increase in the
interest rate decreases
the demand for goods
at any level of output.
By the multiplier effect,
output falls.
The Effects of anThe Effects of an
Increase inIncrease in
the Interest Rate onthe Interest Rate on
OutputOutput

Deriving theDeriving the ISIS CurveCurve
 In Words:In Words:
 ii risesrises ⇒⇒
 InvestmentInvestment fallsfalls ⇒⇒
 The ZZ curve shifts downThe ZZ curve shifts down ⇒⇒
 Equilibrium output falls.Equilibrium output falls.
 ∴∴ In the goods marketIn the goods market, there is an inverse, there is an inverse
relation betweenrelation between ii andand YY..

Deriving theDeriving the ISIS
CurveCurve
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.
The Derivation of the ISThe Derivation of the IS
CurveCurve

Shifts of theShifts of the ISIS CurveCurve
An increase in
taxes shifts the IS
curve to the left.
Shifts of the ISShifts of the IS
CurveCurve
Y C Y T I Y i G= − + +( ) ( , )

Shifts of theShifts of the ISIS CurveCurve
 The IS curve shifts to theThe IS curve shifts to the rightright if:if:
– Taxes fall,Taxes fall,
– Government spending rises,Government spending rises,
– Autonomous Investment rises,Autonomous Investment rises,
 (that is,(that is, II rises for reasons besidesrises for reasons besides ii oror YY))
– Autonomous Consumption rises.Autonomous Consumption rises.
 It does not shift whenIt does not shift when ii oror YY change.change.

Every point on the IS curveEvery point on the IS curve is anis an
equilibrium for the goods market.equilibrium for the goods market.
Income, Y
Interest,i
Y
Z
ZZ,
Medium Interest Rate
Y
Z
ZZ,
Low Interest Rate
Y
Z
ZZ,
High
interest
rate

Every point on the IS curveEvery point on the IS curve is anis an
equilibrium for the goods market.equilibrium for the goods market.
Income, Y
Interest,i
Y
Z
ZZ,
Medium Interest Rate
IS’ (high consumer confidence)
IS (low consumer confidence)

Financial MarketsFinancial Markets
and theand the LMLM RelationRelation
 The interest rate is determined by theThe interest rate is determined by the
equality of the supply of and the demand forequality of the supply of and the demand for
money:money:
5-2
MM = nominal money stock= nominal money stock
PYLPYL((ii) = demand for money) = demand for money
PYPY == $Y$Y = nominal income= nominal income
ii = nominal interest rate= nominal interest rate
)(iPYLM =

Real Money, Real Income,Real Money, Real Income,
 TheThe LMLM relationrelation: In equilibrium, the real money: In equilibrium, the real money
supply is equal to the real money demand, whichsupply is equal to the real money demand, which
depends on real income, Y, and the interest rate, i:depends on real income, Y, and the interest rate, i:
M
P
Y L i= ( )

Deriving theDeriving the LMLM CurveCurve
 Suppose Real Income increases:Suppose Real Income increases:
 YY risesrises ⇒⇒
 People demand more money forPeople demand more money for
transactionstransactions ⇒⇒
 MMdd
shifts out.shifts out.
 If MIf Mss
is vertical,is vertical, ⇒⇒ ii rises …rises …
 …… until the quantity of money demandeduntil the quantity of money demanded
equals the quantity of money supplied,equals the quantity of money supplied,
which is fixed.which is fixed.

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.
Increase in Income onIncrease in Income on
the Interest Ratethe Interest Rate

Equilibrium in financial markets implies that an increase in
income leads to an increase in the interest rate. The LM curve
is upward-sloping.

Shifts of theShifts of the LMLM CurveCurve
If the Central
Bank
increases the
money supply,
the LM curve
shifts down.
Shifts of the LMShifts of the LM
CurveCurve
The LM curve shifts in response to any factor that affects
the money market, except i or Y.

Every point on the LM curveEvery point on the LM curve is anis an
equilibrium for the money market.equilibrium for the money market.
Income, Y
Interest,i
M/P
interest,i
Md
, High income
Ms
M/P
interest,i
Md
, Medium
income
Ms
M/P
interest,i
Md
, Low income
Ms

Putting thePutting the ISIS and theand the
LMLM Relations TogetherRelations Together
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.
5-3
I S r e l a t i o n : Y = − + +C Y T I Y i G( ) ( , )
L M r e l a t i o n :
M
P
= Y L i( )
The IS-LM ModelThe IS-LM Model

Fiscal Policy, Activity,Fiscal Policy, Activity,
 Fiscal contractionFiscal contraction refers to fiscal policyrefers to fiscal policy
that reduces the budget deficit.that reduces the budget deficit.
 An increase in the deficit is called aAn increase in the deficit is called a fiscalfiscal
expansionexpansion..
 Consider an increase in taxes.Consider an increase in taxes.
 Taxes affect theTaxes affect the ISIS curve, not thecurve, not the LMLM curve.curve.

 Suppose the government raises taxes.Suppose the government raises taxes.
 Higher Taxes affect theHigher Taxes affect the ISIS curve:curve:
– They reduce disposable income, so that there isThey reduce disposable income, so that there is
less consumption at every level of Y.less consumption at every level of Y.
Y
Z
ZZ
ZZ Y falls at
every level
of interest.
Y
i
IS
IS’

 Suppose the government raises taxes.Suppose the government raises taxes.
 Higher Taxes do not affect theHigher Taxes do not affect the LMLM curve:curve:
– Neither disposable income nor taxes appear inNeither disposable income nor taxes appear in
the money market.the money market.
i stays the
same at
every level
of Y.
M/P
i
Md
Ms
Y
i
LM

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.
Increase in TaxesIncrease in Taxes

 Higher taxes shift the IS curve to the left and leaveHigher taxes shift the IS curve to the left and leave
the LM curve unchanged.the LM curve unchanged.
 At the old level of interest rates, income has fallen.At the old level of interest rates, income has fallen.
 This causes theThis causes the MMdd
curve to move to the left in thecurve to move to the left in the
money market.money market.
 This causes aThis causes a movement alongmovement along the LM curve.the LM curve.
– The money market changed due to a change inThe money market changed due to a change in YY, so the, so the
MMdd
curve shifts but the LM curvecurve shifts but the LM curve does notdoes not shift.shift.
 Equilibrium is restored at lowerEquilibrium is restored at lower ii and lowerand lower YY..

Monetary Policy, Activity,Monetary Policy, Activity,
 Monetary contractionMonetary contraction, or, or monetarymonetary
tightening,tightening, refers to a decrease in therefers to a decrease in the
money supply.money supply.
 An increase in the money supply is calledAn increase in the money supply is called
monetary expansionmonetary expansion..
 Monetary policy does not affect theMonetary policy does not affect the ISIS
curve, only thecurve, only the LMLM curve. For example, ancurve. For example, an
increase in the money supply shifts theincrease in the money supply shifts the LMLM
curve down.curve down.

 Suppose the Central Bank expands theSuppose the Central Bank expands the
Money Supply.Money Supply.
 Higher MHigher Mss
does not affect thedoes not affect the ISIS curve:curve:
– The Money Supply does not appear in theThe Money Supply does not appear in the
goods market.goods market.
Y
Z
ZZ
Y stays the
same at
any i.
Y
i
IS

 Suppose the Central Bank expands the MoneySuppose the Central Bank expands the Money
Supply.Supply.
 Higher MHigher Mss
shifts theshifts the LMLM curve to the right:curve to the right:
– A greater money supply lowers the interest rate at everyA greater money supply lowers the interest rate at every
level of income.level of income.
i falls at
every
level of Y.
M/P
i
Md
Ms
Y
i
LM
Ms
’ LM

Monetary
expansion leads
to higher output
and a lower
interest rate.
The Effects of aThe Effects of a
Monetary ExpansionMonetary Expansion

 Higher Money Supply shifts the LM curve to theHigher Money Supply shifts the LM curve to the
right and leave the IS curve unchanged.right and leave the IS curve unchanged.
 At the old level of income, interest rates have fallen.At the old level of income, interest rates have fallen.
 This causes Investment to increase, shifting the ZZThis causes Investment to increase, shifting the ZZ
curve up in the goods market.curve up in the goods market.
 The increase in income causes aThe increase in income causes a movement alongmovement along
the IS curve.the IS curve.
– The goods market changed due to a change inThe goods market changed due to a change in ii, so the, so the
ZZ curve shifts but the IS curveZZ curve shifts but the IS curve does notdoes not shift.shift.
 Equilibrium is restored at lowerEquilibrium is restored at lower ii and higherand higher YY..

Using a Policy MixUsing a Policy Mix
 The combination of monetary and fiscal polices isThe combination of monetary and fiscal polices is
known as theknown as the monetary-fiscal policy mix,monetary-fiscal policy mix, oror
simply, thesimply, the policy mix.policy mix.
5-4

The Clinton-Greenspan PolicyThe Clinton-Greenspan Policy
MixMix
Table 5-2 Selected Macro Variables for the United States,
1991-1998
19911991 19921992 19931993 19941994 19951995 19961996 19971997 19981998
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
Over the 90’s, fiscal policy was contractionary and
monetary policy was expansionary. This led to low
interest rates and high output growth.

The Clinton-Greenspan PolicyThe Clinton-Greenspan Policy
MixMix
The appropriate
combination of deficit
reduction and monetary
expansion can achieve a
reduction in the deficit
without adverse effects
on output.
Deficit Reduction andDeficit Reduction and
Monetary ExpansionMonetary Expansion

German Unification and theGerman Unification and the
German Monetary-Fiscal Tug ofGerman Monetary-Fiscal Tug of
WarWar
The Monetary-FiscalThe Monetary-Fiscal
Policy Mix of Post-Policy Mix of Post-
Unification GermanyUnification Germany

How does the IS-LMHow does the IS-LM
Model Fit the Facts?Model Fit the Facts?
The two dotted lines and the tinted space between them gives us aThe two dotted lines and the tinted space between them gives us a
confidence band,confidence band, a band within which the true value of the effect liesa band within which the true value of the effect lies
with 60% probability.with 60% probability.
In the short run, an
increase in the federal
funds rate leads to
a decrease in output and
an decrease in
production,
But so that, for a while,
sales are below
production and inventories
accumulate.
The Empirical Effects ofThe Empirical Effects of
an Increasean Increase
in the Federal Fundsin the Federal Funds
RateRate
5-5

The two dotted lines and the tinted space between them gives us aThe two dotted lines and the tinted space between them gives us a
confidence band,confidence band, a band within which the true value of the effect liesa band within which the true value of the effect lies
with 60% probability.with 60% probability.
In the short run, an increase in the federal
funds rate leads to
an increase in unemployment,
but little effect on the price level.
The Empirical Effects ofThe Empirical Effects of
an Increasean Increase
in the Federal Fundsin the Federal Funds
RateRate

 In general, the IS-LM model seems to beIn general, the IS-LM model seems to be
a pretty good description of the shorta pretty good description of the short
run.run.
– Econometric evidence tells us (withinEconometric evidence tells us (within
certain bounds of error) thatcertain bounds of error) that contractionarycontractionary
monetary policymonetary policy
– Lowers employmentLowers employment
– …… without changing priceswithout changing prices
– (which is what we assumed in this chapter).(which is what we assumed in this chapter).

What did I learn in this chapter?What did I learn in this chapter?
 Tools and ConceptsTools and Concepts
– The IS-LM framework.The IS-LM framework.
 The simultaneous determination of incomeThe simultaneous determination of income
andand interest rates; how different shocks affectinterest rates; how different shocks affect
these two.these two.
– The option of choosing alternative policyThe option of choosing alternative policy
mixes to achieve macroeconomic goals.mixes to achieve macroeconomic goals.
– The use of “+” and “-” below the argumentThe use of “+” and “-” below the argument
of a function to indicate the effect of anof a function to indicate the effect of an
increase in the value of the argument onincrease in the value of the argument on
the value of the function.the value of the function.

What did I learn in this chapter?What did I learn in this chapter?
 RememberRemember
– We still assume prices are fixed,We still assume prices are fixed,
– But we relax the assumptions that investment isBut we relax the assumptions that investment is
independent of the interest rate (assumed inindependent of the interest rate (assumed in
Chapter 3) and that nominal income is fixedChapter 3) and that nominal income is fixed
(assumed in Chapter 4).(assumed in Chapter 4).
– Investment is also allowed to depend on output.Investment is also allowed to depend on output.
– The point of this chapter is to show how goodsThe point of this chapter is to show how goods
and financial markets are related and thus howand financial markets are related and thus how
output and the interest rate are simultaneouslyoutput and the interest rate are simultaneously
determined.determined.
– We continue to assume the economy is closed.We continue to assume the economy is closed.

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