EC 100 Macro Exercise 3 IS-LM

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• Explain intuitively:

Question 1

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Why does the IS generally slope downwards?

• Where does the IS curve come from?

–

Why does the LM generally slope upwards?

• Where does the LM curve come from?

Important that you understand this – and can describe what is happening “behind the scenes”

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r 1 r 0 • To graphically derive the LM curve from the money market… M S M d (Y 1 ) M d (Y 0 ) Y 0 Y 1

LM (M S )

3 Y

Problem 2

•

Describe the effects on IS and LM of:

– an increase in government spending • What else could government do to “help”?

– an increase in the money supply – – a tax cut an increase in bank reserve requirements

Changes in the money market shift the LM curve; changes in the goods market shift the IS curve

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Problem 3

• • • • •

Explain ‘crowding out’

In the goods market/C+I+G model, an increase in government spending raises GDP by the government spending multiplier. The IS-LM model recognizes, however, that when GDP increases, this tightens the money market, thereby raising interest rates. This

part, is what we add in the IS/ LM model – we “endogenize” r

The increase in interest rates chokes off some private investment, and thus C+I+G falls from that level it would have obtained with just increased government spending alone. In summary, increased public spending crowds out private investment. Provided the crowding out is only partial, the end result is an increase in GDP but by less than what would be expected from just the government spending multiplier alone.

In an EXAM provide the graphs that go along with this story.

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Problem 3

•

Crowding out graph(s)

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• •

Problem 4

Describe the effects on (i) output, (ii) employment, and (iii) the price level of: An increase in government spending financed by bond sales.

NOTE: The effect of government bond sales on MS depends on what the government does with the money it receives: (a) Keeps it/does nothing/”sits on it” VS (b) Uses it to increase government spending

– – – – – The bond sales here can be recognized as simply deficit financing.

(i) The rise in government spending shifts rightwards the IS curve. (ii) There is no change in the money supply (WHY?) , so the LM curve remains invariant. (iii) Thus, there is a rise in GDP. (iv) Prices: “Balance between increase in Q and increase in P depends on where the economy is relative to full employment”.

We can see this on the AS-AD curve, discuss in more detail next week

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• A

Problem 4

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Problem 4

• • • • • • Describe the effects on (i) output, (ii) employment, and (iii) the price level of:

An increase in the money supply

(i) There is no change in the IS curve. (ii) The LM curve shifts rightwards. (iii) Thus, there is a rise in GDP. (iv) as in first case – Employment increases if far from full employment – Closer to full employment, more of the increase comes via the price level 9

Problem 4

• • • • An increase in government spending financed by an increase in the money supply

MS increase means that r does not increase (or may increase very slightly) Hence “crowding out” is zero (or very limited)

–

If r does not change, get full multiplier effects of government spending What is the problem of this approach?

–

Will see this formally in coming weeks

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• • • •

Problem 5

Under what conditions will fiscal policy have no effect on the level of income? Vertical LM curve, i.e., complete crowding out. Intuition: For the LM curve to be vertical, people really want to hold more cash balances if their incomes where higher, so much so that interest rates would need to be very high (how high? Very, very high) to get them to reduce their cash balances. Such a steep rise in interest rates reduces private investment to such a degree that GDP remains unchanged, i.e., crowding out is complete.

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r 0 r 1

Problem 5

• A tiny change in Y induces a big change in money demand.

M S

LM (M S )

M d (Y 1 ) M d (Y 0 ) Y 0 Y 1 IS(G0) IS(G1) Y 12

Problem 6

• Under what conditions will monetary policy have no effect on the level of income? •

How does monetary policy affect the level of income?

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• •

Problem 6

If Investment does not depend on the interest rate, the IS curve is vertical Monetary policy has no effect on income LM (M‘ S ) LM (M S ) r 1 r 0 Y 1 Y 0 IS 14