Transcript Introductory MACROECONOMICS - CERGE-EI

0VS452 + 5EN253
Lecture 8 – part II
IS-LM MODEL
Eva Hromádková, 12.4 2010
Overview of Lecture 8 – part II
2
IS-LM model of AD curve:
 Model for AD curve => analysis of stabilization
policies
 IS curve – goods market


LM curve – money market


Fiscal policy – expenditures and taxes
Monetary policy – money supply
Equilibrium – interest rates
IS-LM model
Context
3
We have already introduced the model of aggregate
demand (QTM) and aggregate supply.
Long run
 prices flexible
 output determined by factors of production &
technology
 unemployment equals its natural rate
 Short run
 prices fixed
 output determined by aggregate demand
 unemployment is negatively related to output
IS-LM model
Context II
4
Today we will develop IS-LM model, the theory that
explains the aggregate demand curve
First, we focus on the short run and assume hat price level
is fixed
Then, we allow price to be flexible, and derive AD curve
Finally, we analyze the effect of fiscal and monetary
policy on the most important macroeconomic aggregates
– output and unemployment
IS curve
Keynesian cross
5

A simple closed economy model in which income is
determined by expenditure.
(due to J.M. Keynes)

Notation:
I = planned investment
E = C + I + G = planned expenditure
Y = real GDP = actual expenditure

Difference between actual & planned expenditure:
unplanned inventory investment
IS curve
Elements of the Keynesian cross
6
Consumption function:
C = Ca + MPC*(Y-T)
Govt. policy variables:
G, T
Investment:
I = I(r)
Planned expenditure:
E = C(Y-T) + I(r) + G
(aggregate demand)
Equilibrium:
Y=E
IS curve
Graphing planned expenditure
7
E
planned
expenditure
E =C +I +G
Slope
is MPC
income, output, Y
IS curve
Graphing the equilibrium condition
8
E
E =Y
planned
expenditure
45º
income, output, Y
IS curve
Equilibrium value of income
9
E
planned
expenditure
E =Y
E<Y
E>Y
income, output, Y
E>Y: depleting inventories => produce more
E<Y: accumulating inventories=> produce less
IS curve
Fiscal policy
10

Fiscal stimulus:
 Increase
in government expenditures
 Cut taxes
 Increase transfer payments

Fiscal restraint:
 Decrease
in government expenditures
 Increased taxes
 Decreased transfer payments
IS curve
Increase in government purchases
11
E
E =C +I +G2
E =C +I +G1
G
Looks like
Y>G
Y
E1 = Y1
Y
E2 = Y2
IS curve
Why is change in Y > change in G?
12




Def: Government purchases multiplier:
Y
G
Initially, the increase in G causes an equal increase in Y:
Y = G.
But Y  C (Y-T)
 further Y
 further C
 further Y
So the government purchases multiplier will be greater
than one.
IS curve
Change in G - Sum up changes in expenditure
13
Y  G  MPC  G   MPC MPC  G 
 MPC MPC MPC  G    ...

 
 

 G  MPC 1G  MPC 2 G  MPC 3G ...
This is a standard geometric series from algebra:
1

G
1  MPC
So the multiplier is:
Y
1

 1 for 0 < MPC < 1
G 1  MPC
IS curve
Increase in taxes
14
E
E =C1 +I +G
E =C2 +I +G
At Y1, there is now
an unplanned
inventory buildup…
C = MPC T
…so firms
reduce output,
and income falls
toward a new
equilibrium
Y
E2 = Y2
Y
E1 = Y1
IS curve
Change in T - Sum up changes in expenditure
15
equilibrium condition
in changes
Y  C  I  G
 C
I and G exogenous
 MPC   Y  T
Solving for Y :
Final result:

(1  MPC) Y   MPC  T
  MPC 
Y  
  T
 1  MPC 
IS curve
Tax multiplier
16
Question: how is this different from the government spending
multiplier considered previously?
The tax multiplier:
…is negative:
An increase in taxes reduces consumer spending, which reduces
equilibrium income.
…is smaller than the govt spending multiplier:
(in absolute value) Consumers save the fraction (1-MPC) of a tax
cut, so the initial boost in spending from a tax cut is smaller than
from an equal increase in G.
IS curve
How to derive the IS curve I
17
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:
Y = C(Y-T) + I(r) + G
The IS curve is negatively sloped.
Intuition:
A fall in the interest rate motivates firms to increase investment
spending, which drives up total planned spending (E ).
To restore equilibrium in the goods market, output (a.k.a. actual
expenditure, Y ) must increase.
IS curve
How to derive the IS curve II
E =Y
E
r
E =C +I (r1 )+G
 I
 E
 Y
E =C +I (r2 )+G
I
r
Y1
Y2
Y1
Y2
Y
r1
r2
IS
Y
IS curve
Fiscal policy and IS curve – example of increase in G
At given value of r,
E =Y
E
E =C +I (r1 )+G2
E =C +I (r1 )+G1
G  E  Y
…so the IS curve
shifts to the right.
The horizontal
distance of the
IS shift equals
1
Y 
G
1  MPC
r
Y1
Y
Y2
r1
Y
Y1
Y2
IS1
IS2
Y
LM curve
How to build the LM curve
20
The theory of liquidity preference:


Developed by John Maynard Keynes.
A simple theory in which the interest rate
is determined by money supply and
money demand.
LM curve
Money supply
The supply of real
money balances is
fixed.
r
interest
rate
M P 
M P
s
M/P
real money
balances
LM curve
Money demand
22
r
The demand for
real money
balances is
negatively
dependent on
interest rate.
interest
rate
M
P
s
L (r,Y )
M P
M/P
real money
balances
LM curve
Equilibrium
23
r
The interest rate
adjusts
to equate the
supply and
demand for
money
interest
rate
M
P
r1
s
L (r,Y )
M P
M/P
real money
balances
LM curve
Monetary policy – How can CB affect the interest rate?
24
r
To reduce r, central bank
reduces M.
In reality, this is hardly he
case.
More used technique =
change of discount rate.
interest
rate
r2
r1
L (r ,Y)
M2
P
M1
P
M/P
real money
balances
LM curve
How to derive LM curve?
25
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:
M P  L(r ,Y )
The LM curve is positively sloped.
Intuition: 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.
LM curve
How to derive LM curve II
(b) The LM curve
(a) The market for
r
real money balances
r
LM2
LM1
r2
r2
r1
L (r , Y1 )
M2
P
M1
P
M/P
r1
Y1
Y
IS-LM model
Equilibrium
r
The short-run equilibrium is the
combination of r and Y that
simultaneously satisfies the
equilibrium conditions in the
goods & money markets:
LM
IS
Y  C (Y T )  I (r )  G
M P  L(r ,Y )
Equilibrium
interest
rate
Y
Equilibrium
level of
income
IS-LM model
Fiscal policy: An increase in government purchases
r
LM
1. IS curve shifts right
by
1
G
1  MPC
causing output &
income to rise.
r2
r1
2.
2. This raises money
demand, causing the
interest rate to rise…
3. …which reduces investment, so the
final increase in Y
1
is smaller than
G
1  MPC
IS2
1.
IS1
Y1
Y
Y2
3.
slide 28
IS-LM model
Fiscal policy: A tax cut
r
LM
Because consumers save
(1MPC) of the tax cut,
the initial boost in
r2
spending is smaller for T 2.
r1
than for an equal G…
and the IS curve
shifts by
MPC
1.
T
1  MPC
1.
IS1
Y1 Y2
2.
2. …so the effects on r and Y
are smaller for a T than
for an equal G.
IS2
slide 29
Y
IS-LM model
Monetary Policy: an increase in M
1. M > 0 shifts
the LM curve down
(or to the right)
2. …causing the
interest rate to fall
3. …which increases
investment, causing
output & income to
rise.
LM1
r
LM2
r1
r2
IS
Y1
Y
Y2
slide 30