Goods andFinancial Markets Together:

The IS-LM Model

The Goods Marketand the IS Relation

Equilibrium in the goods market exists when production, Y, is equal to the demand for goods, Z.

In the simple model (in chapter 3), the interest rate did not affect the demand for goods. The equilibrium condition was given by:

Y C Y T I G ( )

Investment, Sales (Y), and the Interest Rate (i)

Now, we no longer assume I (investment) is constantWe capture the effects of two factors affecting investment: The level of sales/income (+) The interest rate (-)

I I Y i ( , )

The Determination of Output

Y C Y T I Y i G ( ) ( , )

Taking into account the investment relation above, the equilibrium condition in the goods market becomes:

The Determination of 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 Goods Equilibrium in the Goods MarketMarket

Deriving the IS Curve

An increase in the interest rate decreases the demand for goods at any level of output.

The Effects of an The Effects of an Increase inIncrease inthe Interest Rate on the Interest Rate on OutputOutput

The IS Curve

An increase in taxes...

Shifts of the IS Shifts of the IS CurveCurve

Financial Marketsand the LM Relation

The interest rate is determined by the equality of the supply of and the demand for money: M Y L i $ ( )

MM = nominal money stock = nominal money stock$YL$YL((ii) = demand for money) = demand for money$Y$Y = nominal income = nominal incomeii = nominal interest rate = nominal interest rate

Real Money, Real Income,and the Interest Rate

The LM relation: In equilibrium, the real money supply is equal to the real money demand, which depends on real income, Y, and the interest rate, i:

M

PY L i ( )

Recall: before, we had the same equation but in Recall: before, we had the same equation but in nominal instead of real terms (nominal income and nominal instead of real terms (nominal income and nominal money supply). Dividing both sides by P nominal money supply). Dividing both sides by P (the price level) gives us the equation above.(the price level) gives us the equation above.

Deriving the LM Curve

The Effects of an The Effects of an Increase in Income on Increase in Income on the Interest Ratethe Interest Rate

Shifts of the LM Curve

An increase in money...

Shifts of the LM Shifts of the LM CurveCurve

The IS and the LM Relations Together

Equilibrium in the goods market (IS).

Equilibrium in financial markets (LM).

When the IS curve intersects the LM curve, both goods and financial markets are in equilibrium.

IS re la tio n : Y C Y T I Y i G( ) ( , )

L M rela tio n: M

PY L i( )

The IS-LM ModelThe IS-LM Model

Fiscal Policy, the Interest Rate and the IS Curve

Fiscal contraction: a fiscal policy that reduces the budget deficit. Reducing G or increasing T

Fiscal expansion: increasing the budget deficit. Increasing G or decreasing T

Taxes (T) and government expenditures (G) affect the IS curve, not the LM curve.

Fiscal Policy, the Interest Rate and the IS Curve

The Effects of an The Effects of an Increase in TaxesIncrease in Taxes

Monetary Policy, the Interest Rate, and the LM Curve

Monetary contraction (tightening) refers to a decrease in the money supply.

An increase in the money supply is called monetary expansion.

Monetary policy affects only the LM curve, not the IS curve.

Monetary Policy, the Interest Rate, and the LM Curve

The Effects of a The Effects of a Monetary ExpansionMonetary Expansion

Recent U.S. Monetary Policy

Using a Policy Mix

The Effects of Fiscal and Monetary Policy.

Shift of ISShift of

LMMovement of

OutputMovement in Interest Rate

Increase in taxes left none down down

Decrease in taxes right none up up

Increase in spending right none up up

Decrease in spending left none down down

Increase in money none down up down

Decrease in money none up down up

German Unification and the German Monetary-Fiscal Policy Mix

U.S. Money Supply during the Great Depression (1928-1936)

U.S. Fiscal Policy during the Great Depression (1930-1947)

The U.S. Recession of 2001

Mr. Greenspan: