Transcript Mankiw 6e PowerPoints

IS & LM Model
Presented
by
MUHAMMAD HASEEB
Assistant Professor
Department of Economics
DA COLLEGE FOR WOMEN PH-VIII, KARACHI
In this topic you will learn:
 the IS curve, and its relation to:
 the Keynesian cross
 the LM curve, and its relation to:
 the theory of liquidity preference
 how the IS-LM model determines income and the
interest rate in the short run when P is fixed
The IS curve
def: a graph of all combinations of r and Y that result
in goods market equilibrium
i.e. actual expenditure (output)
= planned expenditure
The equation for the IS curve is:
Deriving the IS curve
PE =Y PE =C +I (r )+G
2
PE
r
PE =C +I (r1 )+G
I
PE
Y
I
r
Y1
Y
Y2
r1
r2
IS
Y1
Y2
Y
Why the IS curve is negatively sloped
 A fall in the interest rate motivates firms
to increase investment spending, which
drives up total planned spending (PE).
 To restore equilibrium in the goods
market, output (a.k.a. actual
expenditure, Y) must increase.
Factors affecting the slope of IS curve
 Interest sensitivity of investment demand
(responsiveness of investment demand due
to change in interest rate).
Higher the interest sensitivity of
investment demand flatter the IS curve
 Multiplier = 1/(1 – mpc) (for three sector
closed economy model with lump sum tax)
Higher the mpc (lower mps)
higher the
multiplier flatter the IS curve
Factors that shift the IS Curve
•
•
•
•
•
Government purchases
Taxes
Investment
Wealth
Exchange rate (for an open economy)
Fiscal Policy and the IS curve
We can use the IS-LM model to see
how fiscal policy (G and T) affects
aggregate demand and output.
Let’s start by using the Keynesian
cross to see how fiscal policy shifts
the IS curve…
Shifting the IS curve:
At any value of r, G
PE
Y
PE =Y PE =C +I (r )+G
1
2
PE
PE =C +I (r1 )+G1
…so the IS curve
shifts to the right.
The horizontal
distance of the
IS shift equals
G
r
Y1
Y
Y2
r1
Y
Y1
IS1
Y2
IS2
Y
The Theory of Liquidity Preference
 Reasons for holding money classified by
KEYNES according to motive. He
identified the TRANSACTIONS,
PRECAUTIONS and SPECULATIVE
DEMAND FOR MONEY.
 A simple theory in which the interest
rate is determined by money supply and
money demand.
Money supply
r
The supply of
real money
balances
is fixed:
interest
rate
M/P
real money
balances
Money demand
r
Demand for
real money
balances:
interest
rate
L (r )
M/P
real money
balances
Equilibrium
r
The interest
rate adjusts
to equate the
supply and
demand for
money:
interest
rate
r1
L (r )
M/P
real money
balances
How central bank raises the interest rate
r
To increase r,
Central bank
reduces M
interest
rate
r2
r1
L (r )
M/P
real money
balances
The LM curve
Now let’s put Y back into the money demand function:
The LM curve is a graph of all combinations of r
and Y that equate the supply and demand for
real money balances.
The equation for the LM curve is:
Deriving the LM curve
(a) The market for
r
real money balances
(b) The LM curve
r
LM
r2
r1
r2
L (r , Y2 )
r1
L (r , Y1 )
M/P
Y1
Y2
Y
Why the LM curve is upward sloping
 An increase in income raises money
demand.
 Since the supply of real balances is
fixed, there is now excess demand in
the money market at the initial interest
rate.
 The interest rate must rise to restore
equilibrium in the money market.
Factors affecting the slope of LM curve
 Interest sensitivity of money demand
(responsiveness of money demand due to
change in interest rate).
Higher the interest sensitivity of
money demand flatter the LM curve
Factors that shift the LM Curve




Nominal Money Supply
Price level
Expected Inflation
All those factors that change the money
demand (increase/decrease of wealth,
increase/decrease in the risk of alternative
assets, increase/decrease in liquidity of
alternative assets and increase and decrease in
the efficiency of payment technologies
How Money supply shifts the LM curve
(a) The market for
r
real money balances
(b) The LM curve
r
LM2
LM1
r2
r2
r1
r1
L (r , Y1 )
M/P
Y1
Y
The short-run equilibrium
The short-run equilibrium is
the combination of r and Y
that simultaneously satisfies
the equilibrium conditions in
the goods & money markets:
r
LM
IS
Y
Equilibrium
interest
rate
Equilibrium
level of
income
Fiscal Policy
An increase in Government Spending

We begin by examining how changes in fiscal policy
(taxes and spending) alter the economy’s short-run
equilibrium.

An increase in government spending is represented in
the next slide.


The equilibrium of the economy moves from point A to
point B. Income rises from Y1 to Y2 and the real interest
rate rises from r1 to r2.
When the government increases its spending, total income
Y begins to rise (from the Keynesian cross model). As Y
rises, the economy’s demand for money rises and so,
assuming that the supply of real balances is fixed, the
interest rate r begins to rise. As r rises, I falls thus partially
offsetting the effects of the increased government
spending.
Fiscal Policy
An increase in Government Spending
Fiscal Policy
An increase in Government Spending


The increased government spending has “crowdedout” some of the investment spending in the
economy.
The case of a tax cut is similar. This is represented in
the next slide.
Fiscal Policy
A decrease in Government Tax
Monetary Policy
An increase in Money Supply

We now examine the effects of monetary policy. This
is represented in the next slide.



Consider an increase in the money supply. An increase in M
leads to an increase in M/P since we are assuming that P is
fixed. The LM curve shifts downward and the economy
moves from point A to point B. The increase in the money
supply lowers the interest rate and raises the level of income.
This is because the increase in M/P lowers r and this causes I
to increase since I is inversely related to r. This, in turn,
increases planned expenditure, production and income Y.
This process is called the “monetary transmission
mechanism”.
Monetary Policy
An increase in Money Supply
Fiscal And Monetary Interaction

We can now consider simultaneous fiscal and
monetary policy in the IS/LM model in the next slide.



Slide (a) shows the effects of a tax increase, holding the
real money supply constant.
Slide (b) shows the effects of a tax increase,
accompanied by a contraction in the real money supply.
This keeps the interest rate constant in the economy.
Slide (c) shows the effect of the tax cut combined with
an expansion of the real money supply. The effect of
this policy is to keep the level of income constant in the
economy.
Fiscal And Monetary Interaction
The Big Picture
Keynesian
Cross
Theory of
Liquidity
Preference
IS
curve
LM
curve
IS-LM
model
Agg.
demand
curve
Agg.
supply
curve
Explanation
of short-run
fluctuations
Model of
Agg.
Demand
and Agg.
Supply
REFERENCES





Macroeconomics 4th Edition by Gregory Mankiw
Macroeconomics by 7th Edition Dornbusch & Fisher
Macroeconomics by 5th Edition Richard T Froyan
Economics 3rd Edition by John Sloman
Internet
Thank You