Transcript IS-LM Revisited - Villanova University

IS-LM Revisited
Simple Income Determination
Properties of IS & LM Curves
Equilibrium Output & Interest Rates
Economic Policy
(1) Simple Income Determination
*
*
*
*
Eco 1002
Goods Market (IS)
Exogenous Interest Rate & Prices
Endogenous Income (GDP)
(2) IS-LM Model
* Eco 2101 (Keynesian Short-Run)
* (1) + Money Market
* Endogenous Income & Interest Rate (Fixed P)
• Endogenous Policy
Simple Income Determination
(Eco 1001)
• Behavioral Assumptions:
Consumption = C (y, r)
y = disposable income = Y – T
r = interest rate
MPC = C / y  C y
where 0 < Cy < 1
Investment = I(r)
I / r  I r  0
Government Purchases = G
• Exogenous:
r, P, Fiscal Policy: G, T
• Endogenous:
Y
• Linear Examples
• Equilibrium:
Y  C ( y, r )  I ( r )  G  E
• Some Basic Results:
Cr  I r
dY / dr 
0
1 Cy
(interest rates and GDP)
1
dY / dG 
1
1 Cy
(Gov. Spending Multiplier)
dY / dT 
 Cy
1  Cy
0
(Tax Multiplier)
IS-LM Model (Eco 2101)
• Goods & Money Market Equilibrium
• IS-LM Model
Exogenous: P, Fiscal Policy: G, T
Monetary Policy: Ms
Endogenous: Y and r
IS and the Goods Market
• Goods Market Equilibrium:
Y = C(y,r) + I(r) + G
(IS equation)
where y = Y – T = disposable income
0< Cy < 1
Ir < 0
G and T are exogenous policy
variables
• Properties of IS curve:
Slope*: dY
Cr  I r
0
IS 
dr
1 Cy
Government spending multiplier:
dY
1
(shifts right)
dG

1 Cy
1
Tax Multiplier:
dY  C y

0
dT 1  C y
(shifts left)
LM and the Money Market
• Real Money Demand = L(Y,r)
L / Y  LY  0
L / r  Lr  0
• Money Market Equilibrium:
Ms = P*L(Y,r)
(LM equation)
Ms is an exogenous policy variable.
• Properties of LM curve
Slope*:
dY
dr
LM
Lr

0
LY
Real Money Supply:
dr
1

0
s
d ( M ) PLr
(shifts right)
• The Simple IS-LM Model - (Y,r) which
solves:
Y  C ( y, r )  I ( r )  G
(IS)
M  P * L(Y , r )
(LM)
s
Policy in IS-LM Model
Exogenous: P
Endogenous: Y, r
Policy Variables:
G, Ms, T
• Fiscal Policy
(1) Government Expenditures (dG)
Lr
dY *
1


0
dG (1  Cy )Lr  L Y (Cr  I r ) (1  Cy )  (Cr  I r )(LY / Lr )
but less than 1/(1-Cy)!
 LY
dr *

0
dG (1  C y ) L r  L Y (Cr  I r )
Crowding-out effect!
• Effectiveness of G:
If
or
then
I r , Cr  
Lr  0
dY
dG
0
(IS Flat)
(LM verticle)
.
(Complete crowding-out!)
(2) Taxes (dT): dY/dT = ?, dr/dT = ?
• Monetary Policy (dMs):
dY *
I r  Cr

0
s
dM
(1  C y ) PL r  PL Y (Cr  I r )
1  Cy
dr *

0
s
dM
(1  C y ) PL r  PL Y (Cr  I r )
• Effectiveness of monetary policy:
If
(IS vertical)
I r , Cr  0
or
Then
Lr  
dY
dM
s
0
(Ineffective Monetary Policy)
(LM flat)
Liquidity Trap and Interest Rate
Insensitivity
• Great Depression
Year
UR
1930
8.9
1931
16.3
1932
24.1
1933
25.2
1934
22.0
1935
20.3
1936
17.0
i
3.6
2.6
2.7
1.7
1.0
0.8
0.8
p
-2.6
-10.1
-9.3
-2.2
7.4
0.9
0.2
r=i-p
6.2
12.7
12.0
3.4
-6.6
-0.1
0.6
• 2008-09 Recession
Jan 2007 – Jan 2010, Federal funds rate
cut from 6% to 1%.
i
UR
Jan 2007
5.25%
4.6%
Jan 2008
3.94%
5%
Jan 2009
0.15%
7.7%
Jan 2010
0.12%
10%
Business Cycles in IS-LM
• Shocks to Consumer confidence (g):
C = C(Y,r,g) where Cg > 0
 dY*/dg > 0
dr*/dg
0
• Shocks to money demand (s):
L = L(y,r,s) where Ls > 0
 dY*/ds < 0
dr*/ds  0
Endogenous Policy
• Monetary/Fiscal Policy responds to economic
conditions to achieve goal.
Objective:
dY = 0 (output stability) OR
dr = 0 (interest rate stability)
Exogenous: Policies - Ms or G, or T
Shocks – g or s
Endogenous: Policies - Ms or G, or T
• Example: An increase in G and Fed’s objective
is to keep r constant (prevent crowding out).
• Step 1: Set dr = 0
Step 2: Treat dY and dMs as endogenous, dG
as exogenous.
Step 3: Use Cramer’s Rule to solve for
dY/dG and dMs/dG.
Suppose instead Fed wanted to keep output
stable (dY = 0). Find dr/dG and dMs/dG.
Evaluation of Simple Keynesian ISLM Models
• Provided reasonable explanation of
business cycles.
• Guides policymakers on stabilizing
economic fluctuations.
• Can be applied easily to think about
current events.
Shortcomings
• Criticisms of IS-LM Model:
(1) Emphasis on aggregate demand.
(2) Static Model.
(3) Lack of solid microeconomic
foundations.
• Lucas Critique on Policy Evaluation
• Examples: Consumption, Phillips Curve
Modern Macro
• Dynamics
• Expectations (rational)
• Microeconomic Foundations
Most modern macro models (New Classical
and New Keynesian) have these features.